Options could be very useful tools for your trading arsenal during the highly volatile times of earnings’ season. They offer various combinations for more precise risk and performance management.
Selling a strangle (two OTM options)
Let take for example CME, which reports tomorrow, before market open. It is currently trading for $ 166.14. You look at its option chain and notice that: FEB 150 PUT is trading for $5.80 and FEB 180 CALL is trading for $6.80. You figure out that their earnings’ report won’t cause a significant stock’s move in neither direction. Then, you decide to benefit from the elevated implied volatility before the announcement by collecting premium from selling the above mentioned out-of-the-money contracts. The net result: a premium of 12.60 (1260 for the strangle) in your pocket.
– you keep the entire premium if CME closes in the 150-180 range at option expiration, which in this case is FEB 20;
– the position is profitable in the 137.40 – 192.60 range, since the received 12.60 premium upfront will offset a possible appreaciation in the put option if CME dives (break-even at 137.40 – brokers’ commisions) and it will offset possible appreaciation of the call option if CME jumps up (break-even at 192.60 – broker’s commisions);
– the downside of this strategy is unlimited and losses starts below 137.40 and above 192.60;
Selling a credit spread
Let say you are bearish on CME, but you don’t want to short the stock in front of an earnings’ event that might move it 20 points overnight in either direction. You don’t want to buy a put option of the stock, because premiums before such major announcement are highly elevated. An alternative approach for your bearishness is to use a bear call spread. In our CME example, you might buy FEB 175 CALL for 8.50 and sell FEB 160 CALL for 15.50. The net result is $7.00 in your pocket.
– your maximum gain could be $7.00 (or 700 for the spread) if CME closes below 160 at options’ expiration (FEB 20), because in such case both options will expire worthless and you will keep the credit;
– your maximum loss is $8.00 (or 800 for the spread) if CME closes above 175 at expiration, since at 175 your long call (FEB 175) will be worthless and your short call (FEB 160) will costs $15.00 per share;
– Break-even is at $167;
Call Ratio Backspread
Let say that you expect CME’s earnings report tomorrow to cause a significant move in the stock. You don’t want to buy a strangle or call and to pay premium before earnings and you have bullish expectations. In this case you might sell FEB 160 CALL for $15.50 and use the proceeds to buy 2 out-of-the-money calls. For example you might purchase two FEB 175 CALLS for 8.60 each or a total of 17.20. The net result will be a money outflow of $1.70 (17.2 – 15.5).
– maximum gain is unlimited and starts above 191.70; At 190, the short call cost 30, but the two long calls cost 15.00 each and from 190 + 1.70 up, the long position will appreciate much faster than the short, resulting in a net gain.
– maximum loss is 16.70. If CME closes at 175 at options’ expiration, your short call position will cost $15.00 and your long calls will be worthless;
– if CME dives on earnings and closes below 160 at options’ expiration, all calls will be worthless and your loss will be limited to the paid premium difference of 1.70 per share (or 170 for the whole spread);
There are many other way to utilize options for hedging and speculation and I might talk about them in another post.