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Understanding the Risks of Buying Spreads in Advance of an Earnings Announcement
For options traders, one of the most interesting opportunities comes just before a company announces their quarterly earnings. At that time, there is a huge run-up in option prices for the options which expire shortly after the announcement date. For many actively-traded companies, those are weekly options.
As you surely know by now, when we talk about option prices being high we are referring to implied volatility (IV) of the options.
When IV escalates, options traders typically like to sell those options and at the same time buy other options which have a lower IV as a hedge in case the options they sold move even higher after the announcement.
One popular way to play the announcement game is to buy a calendar spread (buying a longer-term put or call and selling the same-strike weekly or other shorter-term option against it). If the shorter-term option will be expiring just after the announcement, its IV will almost always be much higher than the longer-term option that you are buying.
If you buy an option that is decaying at a much slower rate than the option you are selling, you are considered to have an IV advantage, and unless the stock moves dramatically one way or the other, you should make gains over time.
However, there are two extremely important considerations surrounding announcements. First, stock prices tend to fluctuate by very large amounts just after the announcement. Calendar spreads do very well if the stock ends up exactly at the strike price when the short options expire. The further away from the strike price it moves, the less it will make. If you bought an at-the-money calendar spread and the stock moved a great deal after the announcement, you would most surely lose money.
Second, once the announcement is made, IV of option prices will fall for essentially all the options series. Inexperienced options investors might pre-test a calendar or diagonal spread on a graphing package (like thinkorswim’s Analyze Tab) and believe that their spread will make money if the stock fluctuates by less than 5% in either direction. The problem, however, is that IV will fall for the long side of the spread, and the expected gains might well end up being a loss. It is possible to adjust the software to account for how much you expect IV to fall, but it is not as easy adjustment and most investors don’t seem to go through that process before plunking their money down.
In the GMCR spread I recommended last week, with the company trading about $78, we bought Dec-13 well in-the-money calls at the 67.5 strike and sold Aug2-13 weekly calls at the 77.5 strike. We paid just under $11 for the spread. I selected the Dec-13 series because implied volatility of those options (55) was lower than any other weekly or monthly series, and since the December expiration comes well after the next earnings announcement in late October or early November, IV was not likely to plummet after Wednesday’s announcement like the August, September, and October options would probably do.
If you paid about $11 for that diagonal spread, if the stock stayed flat or moved higher by any amount, the spread could never be worth less than what you paid for it because that is only one dollar more than the intrinsic value (the difference between 67.5 and 77.5). Since the call option that you own has several more months of remaining value, there will be a time premium in that option over and above the intrinsic value. The stock could go up by 30% and the time premium for that option would still be more than $1.
If the stock were to fall, it would have to fall quite a bit before the value of the Dec-13 67.5 call would fall below $11 (it was trading above $15 when we bought it). We calculated that it could fall about 8% ($6) before a loss would come about (remember, it fell $2 and we made 25%).
So how much did IV fall for the various options series after GMCR announced last week? Here are IVs for the various months which existed on Tuesday, December 6 just before the announcement and on Thursday, December 8 after the announcement.
Month IV Before IV After Difference
Aug2 (weekly) 148 40 108
August 96 37 53
September 61 41 20
October 55 42 13
December 55 49 6
Notice the huge difference in the diminution of IV as you get into further-out months. The smallest drop by far was in the December options which expire after the next announcement.
Bottom line, while the further-out options cost quite a bit more, they are far less likely to fall in value by large amounts after the announcement. The series that expires after the next announcement (it would have to be at least 90 days further out) will fall by a much smaller amount than any of the other monthly options series.
While you can reduce your risk of the long options falling too much by buying the series which will expire after the next earnings announcement, you are still exposed to the risk of a huge downside move of the stock. You would only want to place a bullish diagonal spread like this one for a company you liked enough to believe that it was not likely to crash after the earnings announcement. It is nice to understand that you don’t have to be totally right – it can fall and the spread can yield a good gain as well, just as long as it doesn’t fall too much.
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Terry
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