J.P. Morgan was once asked what the stock market will do and he famously replied: “It will fluctuate.” Let’s face it, the market is hardly predictable. But here’s one thing we can bank on: once every quarter, publically traded U.S. companies by law must report their financial status, more commonly known as earnings announcements. And these releases produce some interesting situations in options.
First, the Conundrum
Like any other commodity, options are influenced by supply and demand. And earnings announcements are one of those events that can create demand for options, meaning some investors are more likely to buy rather than sell them. Here’s why: first, stocks can make big moves on the back of headlines, so some investors buy options (calls, puts, or a combination of both depending on the forecast) to make a leveraged bet. Second, when investors own a stock that’s about to report earnings, they may want to buy a put option to protect their position in case the stock tanks (buying a put locks in the right to sell the stock at a set price for a set period of time).
This excess demand can drive up prices, so option buyers have to be mindful of cost. Another factor that affects option prices is time to expiration. The further out you go the more an option costs, so around earnings, many traders tend to go with the shortest time frame they can. As recently as a few years ago, traders were limited to options that expired on a monthly basis. What if the nearest-term expiration was 40 days away but earnings were in a few days? You’d be forced to pay for a whole bunch of time you didn’t need.
Luckily, the options market has adapted to this dilemma by creating weekly options. For certain stocks, options are listed with their expirations each week, for five weeks out, in addition to regular monthly expiration cycles. Weeklys give option buyers the flexibility to better control the outlay for a given strategy.
Using a recent example (Figure 1), a certain new entrant in the auto sector reported earnings after the market closed. Looking at the option chain of XYZ in Figure 1, suppose an investor owned 100 shares but was worried about a disappointing report. Buying a $175 strike put would give them the right to sell the stock at $175, no matter how low it went. Notice the cost differences: $9.20 for the Weeklys expiring that week (plus commissions and fees), $10.45 for the monthly November expiration (or 15% higher), and $15.00 for the December expiration.
Since the protective put was only needed for a short time (to get through the earnings news), the weekly option offered a cheaper alternative to the regular monthly options. Incidentally this protective put would have come in handy because the report was disappointing, and stock prices dropped from $176.81 to $151.16 (and actually fell near $120 a few weeks later). On the flip side, if the report were stellar, and the stock took off, and the put expired worthless, you’d lose all of your investment.
Or suppose you were bullish and purchased the $185 call option. Again, doing the price comparison shows $6.50 for the Weeklys, $7.70 for November expiration, and $12.20 for December. Every extra dollar paid moves the trade’s breakeven point higher, meaning the stock has to go up even more to compensate. Now, bear in mind, because they’re short-lived, you need to watch Weeklys closely. Volatility can be significant. And if the stock move is less than the effect of volatility, your profit could suffer a “volatility crush,” thereby turning your gains into losses.
Buying options around earnings announcements can be a tricky game but weekly options can help give traders the ability to buy only the time they need. Now, can we get a better answer to that age-old question that J.P. Morgan so eloquently dodged?
Here Come the Earnings
Join in on Wednesday, July 8, 2015 when Shawn Cruz from TD Ameritrade will host a webcast on WeeklysSM Options Strategies for Earnings Season. And it’s timely—earnings season starts that week.