Spreading - Play Earnings with an Options Technique - Investing Shortcuts

Spreading – Play Earnings with an Options Technique

By September 27, 2016Options

Earnings season is a time of heightened uncertainty. This translates into higher options premiums. After the event, premiums return to more normal levels. In the chart below, the orange line, which tracks the history of implied volatility, shows us that as earnings approaches, the level of premiums increases.

Earnings Play Chart

(source: Options House)

If you are looking to play earnings using options, be aware of this condition. Many traders I have coached were unaware of this. What this means is that buying options prior to earnings requires the stock make a bigger move in order for the trade to be profitable. The options market is already pricing in the potential for a big move!

An alternative approach to buying options outright is to use the vertical spread – buy a lower strike call and sell a higher strike call. With a stock at $100 and earnings approaching, the 10-day calls are priced as follows:

100 Call = $4.00 102.5 Call = $2.88 105 Call = $2.03 107.5 Call = $1.40

If one is bullish on the stock’s response to earnings, one could buy the 100 Call for $4.00 and sell the 107.5 Call for $1.40, creating the vertical spread for $2.60. The trade looks like this:

Earnings Play 2

Risk is lowered to $260. Maximum profit is $490, which is calculated by subtracting the cost from the maximum value of the spread – the difference between the strike prices. By employing the spread, the trader does not need the stock to move as much to generate profits.

Spreading is a powerful option trading technique all traders should explore and consider.

Elliot Katz

Author Elliot Katz

Elliot Katz has over 30 years of experience in the stock, options and futures markets. He has served as an options strategist and an institutional options broker. From 1989-1992, he was an instructor for The Options Institute of the CBOE. Throughout the 1990’s and early 2000’s, Elliot had roles in Senior Management at national wirehouses and private banks. Since 2007, he has worked as an independent advisor, trader, and educator.

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