Spring is finally in the air after another long dark winter. April ushers in several great traditions: the Final Four, the opening of Major League Baseball, the Masters Golf Tournament, and a new round of corporate earnings for eager investors.
Public companies release earnings results four times a year to account for financial performance during the previous quarter. Think of earnings as a report card for public companies. The news release is typically accompanied by a conference call, where the company executives share insights, provide guidance, and answer questions from investors and analysts.
Earnings are typically reported before the market opens or after the close. These reports can sometimes prompt sharp price swings in a stock as traders react to and discount new information. You can learn when a company reports earnings by going directly to their investor relations website or by utilizing data from thinkorswim charts as seen in figure 1 below (look for the red phone icon at the bottom of the chart). Keep in mind that some earnings dates are not confirmed until just prior to the release date, and these dates can change.
Earnings Season: Risks and Potential Rewards
Earnings season offers a unique opportunity to participate in some of a stock’s most active and volatile periods of the year. Owning stock during this time can be beneficial, but also carries with it a certain degree lots of risk. For instance, if a company disappoints by reporting earnings that are less than investor were expecting, the stock can falter quickly, bringing with it a risk of sizeable losses.
Options as a Hedge
Have you ever considered using options as protection for an existing stock position in your own portfolio? Coming into earnings with an existing stock position can make any investor nervous. Using options as a hedge against potential losses while holding on to a stock can help prevent some sleepless nights. For instance, let’s say you own 100 shares of Disney (DIS) currently trading near $100, but you want to shield against potential losses with earnings coming out in early May. If you want to protect against the stock falling below $95, and were willing to sell the stock at $105, this scenario could be accomplished using options.
One popular strategy that shareholders use to protect an existing stock position is a collar spread. This strategy allows an investor to limit potential losses while being able to still capitalize on a limited upside. This trade could be constructed, for example, by simultaneously buying 1 May 95 put while selling 1 May 105 call. Collars can be customized to match an investor’s expectations of the stock’s rise or fall around earnings or any other scenario for that matter.
Options as a Risk-defined Speculative Trade
Not only are options a valuable tool to protect existing positions, but they can also be used in situations where you may want to capture a stock move during an earnings event. Options can be utilized as an alternative to owning stock during earnings. They have the ability to capitalize on the same price action as stock, but with a fraction of the capital and risk (as long as they are being implemented in a risk-defined manner). Owning a stock is fairly one-dimensional, with holders profiting on the way up while losing on the way down. Options have the versatility to gain from a stock’s rise, fall, or range-bound movement around different earnings result depending on the strategy implemented.
As an example, a trader could purchase 100 shares of Facebook (FB) trading near $115 which would require $11,500 in capital (not including transaction costs). Or, a trader could substitute the shares by buying 1 115 May call option at just a fraction of the cost. Let’s assume the option is priced at $5.00 for a $500 total investment (not including transaction costs). This also represents the total amount of risk for the trade. Suppose the company announces a worse-than-expected earnings report and the stock drops $10 in response. In this case the stock position would lose $1,000 compared to a $500 loss on the option.
Weeklys and Earnings Season
Weekly options have transformed the way option traders approach earnings on several of the most actively traded companies. Traders now have the ability to pinpoint the timing of expiration to match the week of a company’s earnings announcement, which helps to reduce the overall cost of the trade.
Now, let’s revert back to the Facebook example with earnings scheduled for April 20th. A trader could choose to buy the more expensive May options (expiring on May 20th) (see figure 2) which would capture the event, plus an additional 28 days of time premium, for current price of $5.25.
Alternatively, a trader could choose to utilize a shorter-term weekly option that expires on the 22nd or the 4th Friday of April (see figure 3) priced at $2.94 (44% cheaper) to isolate the exact week of the event. Thus avoiding the need to pay for excess time premium.
In summary, with earnings just around the corner, consider using options to either protect a current holding or speculate on how your favorite stocks might move after the next earnings report. These are just a few of the strategies that can capitalize on the movement of stocks around earnings, while using options in a risk defined manner. Stay tuned for additional segments on how to compliment your account with options.
RED Option is a professional advisory service that specializes in educating investors on how to employ option strategies in current market conditions. If you would like to learn more about the versatility of options visit our website at www.redoption.com.
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