Two Options Plays for Earnings Season

Despite the promise of an improving economy, a year-end Santa Claus rally and the perennial hopes of investors eagerly awaiting the arrival of the great pumpkin -- I mean the January rally -- stocks opened the new year stumbling badly just as the reporting season starts to unfold.

But like Linus, who had his little blue blanket to give him comfort, traders entering this season's earnings patch can use options to achieve a sense of security while retaining a level of opportunistic equanimity.

Rather than making predictions regarding companies likely to provide earnings surprises, I'm using scheduled release dates to find attractive risk/reward option positions in companies scheduled to report earnings next week.

Of course, earnings reports, especially this quarter, can produce some big initial opening gaps, spikes and reversals that seem custom-made for using short-dated options. With January options expiring in just nine days, the leverage offered is tempting. But given the time decay (remember, markets are closed on Monday, which dials time forward), it makes the pricing configuration such that only at-the-monies are retaining any value.

This drastically reduces strategic choices to either outright purchase or sale, and hoping that you get the initial reaction correct. For example, it makes little sense to establish a vertical spread if the out-of-the-money option brings in only a dime of premium.

Look Beyond Next Week

It is certainly alluring to buy cheap options hoping to get earnings-day action, and I know every quarter always delivers some jackpot payoffs. I don't want to discourage anyone from being in it to win it, but be selective. Although buying options is certainly less risky in dollar terms than buying or selling the underlying shares, the price of these short-term options tends to be inflated as the implied volatility gets pumped up prior to the earnings release. This means that unless you are really right in predicting a sizable move, these bets usually don't amount to anything more than a lottery ticket, which often results in losing the full purchase price.

That's why in many instances it makes sense to look beyond employing some longer-dated options; they can offer not only better value, but they also supply enough time for the investment thesis to play out. In addition, longer-dated options allow for making adjustments during the position's life that can lock in profits and contain losses.

F5 Networks

F5 Networks ( FFIV) is scheduled to report Jan. 19. The company is expected to earn 21 cents per share, which would be a 90% increase over the year-ago period.

F5 Networks
A calendar spread makes sense here
Source: BigCharts.com

The shares have had a nice run, doubling over the past five months. But as this recent pullback from $49 to $43 suggests, the stock could use a little rest if it's going to work back toward the highs. The chart also suggests the stock may be vulnerable to completely rolling over. So if you're looking at bullish positions, employ only those with limited downside risk.

A calendar spread makes sense in this situation, given the options pricing skew and expectations for the stock to take a little time to work higher. The anticipation of earnings has created a small skew in F5 Networks' options; the January at-the-money calls have an implied volatility near 70% while the February series have a 58% implied volatility.

With the stock trading at $42.50, you can sell the January $45 call for $1 and buy the February $45 call for $2.20 for a net debit of $1.20. The position benefits if the spread between the price of January and February calls widens. This will occur if the stock remains at its current level or moves moderately higher toward the $45 strike by January's expiration next Friday. You will then be outright long the February call, which will have a break-even point of $46.20 per share and unlimited upside potential. The maximum loss is $1.20, or $120 per spread or equal to the position's net debit.

Ameritrade

Due to report Jan. 18, Ameritrade ( AMTD) is expected to earn 19 cents per share. Although estimates have increased from an average of 16 cents 60 days ago, the stock has tumbled this week and now stands at the same $13 level it was in early November when the upgrades and raised guidance commenced.

The chart pattern looks poor, but there is support at $12. I believe that price should hold; it represents a good place to start accumulating shares. Right now implied volatility of Ameritrade's near-term options is around 43%, near the top end of their 52-week range.

To take advantage of this relatively rich pricing, I'd suggest looking to sell the February $12.50 put for 50 cents, which gives you a break-even point of $12 per share, the price at which I'd be a willing buyer of stock. But I'd also consider buying some May $15 calls for 50 cents per contract, which represents an implied volatility of just 33%, to gain some more upside potential over the next five months. The combination, which is essentially a synthetic long position, can be done for even money.

The advantage of this position over simply buying the stock is that your effective purchase price should the stock dip is $12.50, or 4% below the current market price. The position also provides over four months of upside exposure for free, as the sale of puts pays for purchase of the call.

Note that this is not risk-free until the February put expires worthless: A short put has the same downside as being long the stock. One drawback here is that the position will not deliver a profit if Ameritrade does not rise above $15 by May expiration; it simply breaks even if the stock stays between $12.50 and $15 per share.

There are many ways to squash a pumpkin and still end up with pie -- these are just two suggestions. I'll be offering more as earnings season rolls along.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from 1989 to 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

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