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Earnings Season Has Arrived – How to Capitalize on it With Options:
In the last few weeks leading up to a quarterly earnings announcement, two things usually happen. First of all, the stock often moves higher as the announcement day approaches as some investors start hoping that the company might beat expectations. The second thing is even more likely (and essentially always happens). Implied Volatility (IV) of the option prices moves much high. This means that the prices for options temporarily rise in value across the board. The greatest upward move in IV takes place in the options series which expires just after the announcement date.
The reason that IV becomes greater at this time is that once earnings are announced, the stock is likely to move either up or down by a much larger amount than it does most trading days. When volatility is expected to be high, option prices rise in anticipation of that higher level of anticipated price changes.
One of my favorite option plays is based on these two tendencies to occur as the announcement day approaches. I like to leg into a calendar spread at a strike price which is slightly higher than the stock price. I do this by buying a call option at that strike in the option series that expires two weeks after the series which expires just after the announcement is made. Once I have made my purchase, I place a good-til-cancelled order to sell a call at the same strike in the series that expires just after the announcement date (the series which will carry the highest IV and therefore the highest option prices). I set a limit price which is sufficiently greater than what I paid for the two-week-longer call to cover the commissions and leave a small profit as well.
This limit price should be met if either or both of the tendencies end up happening (the stock moves higher or IV increases). Most of the time, I have been able to complete the trade and end up with a calendar spread at a credit.
If I am successful in setting up a calendar spread at a credit, I am guaranteed to make a nice profit on the spread. I can’t lose because the call I own has two weeks more of life than the same-strike call I have sold to someone else, so it can be sold at a credit, no matter what the stock price does after the announcement. My greatest gain will come if the stock ends up very close to the strike price which I selected.
The Starbucks (SBUX) Play: SBUX announces on April 21. Two weeks ago, with SBUX trading about $58.60, I placed an order to buy SBUX May1-16 calls. I paid $1.12 ($112 per contract) plus $1.25 commission at the rate paid by Terry’s Tips subscribers at thinkorswim (if you are paying more than this as commission rate, you might consider opening an account at this brokerage – see the offer below).
I immediately placed an order to sell Apr4-16 60 calls at a limit price of $1.20. The Apr4-16 series expires on April 22, the day after the announcement on the 21st. This trade executed the very next day. After commissions, I had gained $5.50 for each spread, and was guaranteed to make an additional gain once the Apr4-16 calls expired. Since the May1-16 calls have two weeks more of remaining life than the Apr4-16 calls, the spread will always have at least some value. The closer the stock is to $60, the greater the value of the spread. If I am lucky enough to see it end up at $60 on April 22, I could expect to collect about $80 for each spread (on top of the $5.50 I already have collected).
The Facebook (FB) Play: One week ago today, knowing that FB would announce earnings on April 27, when the stock was trading at $112 (it had fallen $4 at the open from Friday’s close because an analyst forecast that their earnings would disappoint). I bought May2-16 114 calls for $4.40 ($440 plus $1.25 per contract, or $441.25). I then placed a good-til-cancelled order to sell Apr5-16 114 calls for $4.50. These calls would expire on April 29, two days after the announcement on the 27th.
Both the stock and IV of the Apr5-16 options rose on Tuesday, and my trade executed. IV for the Apr4-16 series was 40 when I reported this trade to you two weeks ago, and it is now 48. Now I am guaranteed a profit in FB as well, and I am rooting for the company to exceed expectations and a $114 price come along after the announcement. (As I write this, FB has fallen further, to about $110).
There is something nice about holding an options investment that is guaranteed to make a gain no matter what the stock price does. Most of the time, I would be anguishing when my stock is dropping in price.
Closing Out the Trades: On the Friday when the short calls in these calendar spreads expire, you will have to make a decision. If the stock price is trading at a lower price than the strike price, you don’t really need to do anything as the short calls will expire worthless. However, you might want to buy them back at a nominal price (if that price is $.05 or lower, thinkorswim does not charge any commission, by the way). You would only buy them back if you also planned to make a sell trade as well. You could either sell the call you own which has two weeks of remaining life (essentially closing out the calendar spread), or you might sell the same-strike call which has one week of remaining life (this sale can almost always be made at more than 50% of what you could sell the two-week-out call).
A third alternative would be let the short call expire worthless and just hang on to your long calls (remember, they did not cost you anything at the beginning), and hope for a windfall gain if the stock manages to soar.
Most of the time, I resist buying puts or calls outright, preferring instead to be a seller of short-term options. But every once in a while, it is fun to hang on to an option and see what might happen, especially when it didn’t cost me anything. It is sort of like getting a free lottery ticket (with better odds but a smaller pay-off than the lottery offers).
If the Sell Trade Doesn’t Execute: Some of the time, the stock will fall after you have made your call purchase and IV doesn’t rise enough to force an execution on your sell order. In those cases, I wait until the end of the day just before the announcement and sell the same call in my good-til-cancelled order at whatever price I can get. I have found that the stock often ticks up in the final hour of that day, and I can get a better price than earlier.
The calendar spread that you have created will not be made at a credit, but it still might be cheap compared to usual standards because of the elevated IV of the call you are selling.
Another alternative might be to sell your long call. It might be sold at a small profit, or more likely, a small loss. Even if the stock has fallen, IV might have moved high enough to make the option worth more than you paid for it.
This Week’s Trade, Abbvie (ABBV): ABBV is a drug company that pays a high dividend and doesn’t fluctuate very much. For these reasons, IV and option prices are quite low, but that doesn’t mean you can’t make gains with this same strategy. ABBV announces earnings before the market opens on April 28th.
With the stock trading about $58.50 this morning, I bought ABBV May2-16 58.5 calls for $1.87. This series closes two weeks later than the Apr5-16 series which expires on April 29, just after the April 28 announcement date. I have placed a good-til-cancelled order to sell Apr5-16 58.5 calls at a limit price of $1.95. IV for this series is currently 34 and can be expected to rise over the next week or two.
I selected the 58.5 strike instead of a higher strike because there is a $.57 dividend payable on April 13 (tomorrow) which may depress the stock by about that much. In fact, you might want to wait until tomorrow to buy the Apr5-16 call because it might be cheaper then.
I will report back to you on how these trades end up.
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Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts. seth@terrystips.com
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Terry
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