Earnings season—pageant time for the companies that you’re not only familiar with, but whose products you possibly consume daily. It’s a bustling time for potential market-moving news and a good time to get familiar with streamlined trading tools, including Order Entry on the thinkorswim® platform (figure 1).
Here, we’re revealing the platform features that allow traders to put on multi-leg option trades in a few steps. But first, let’s cover why multi-leg trades, or spreads, might make sense for some qualified option traders in their approach to earnings season.
Making Elevated Premium Work for You
For shareholders, earnings season is an opportunity to see if the company’s management has been a good shepherd of your investment. For others, earnings, revenue, and forward-looking guidance could provide potential inspiration for a new position. Regardless of the reason behind your active interest, you may find yourself thinking: “If I had the money, I would (buy/short) shares of Company XYZ.” Is there a way to speculate on the post-earnings move without the upfront capital that a straight stock trade might require? If the company’s stock is publicly traded and has options, the answer is yes.
Let’s say your target stock currently trades for $100 and you feel strongly it could head higher. Challenge One: Buying 100 shares will cost you $10,000. Now, options give you an alternative way to take a position on your hunch for the stock move after earnings but typically at a fraction of the cost. Buying a call option (the right but not the obligation to purchase the underlying stock at a future, set price and time) may be the first thing that comes to mind when taking a bullish stock position via options. Challenge Two: Around earnings time, an option that may typically be inexpensive can cost substantially more. In addition to increased costs, traders have now pushed their breakeven level higher.
But who says you have to be the buyer in this little scenario? Perhaps there can be some benefit to selling the high-priced options? Ask yourself: if calls gain value as a stock moves higher, is there something else that loses value? Everything else equal, put options (the right but not the obligation to sell the underlying stock at a future, set price) lose value as the underlying instrument moves higher. It would follow that selling puts on a company could be a useful tool in playing an upside hunch following earnings.
So, we’ve already talked about how expensive purchasing shares outright can be. Someone might rightfully point out that selling puts can also come with a high buying power requirement. For some accounts, the buying power needed to sell a put can be equally as prohibitive as purchasing shares. One alternative might be to buy a put at a lower strike price than the one you’re thinking about selling. Doing so can help you define your risk. Selling a naked put—you don’t own the underlying shares—gives you risk all the way down to zero and thus a high buying power requirement. However, selling a put spread—a strategy that involves buying and selling equal numbers of put contracts simultaneously—can come with a significantly lower buying power requirement. You’re still taking a speculative position on the underlying company of your choice, but not betting the farm. Keep in mind that spread strategies can also entail substantial transaction costs, including multiple commissions, which may impact any potential return.
What If I’m Wrong?
By selling a put spread that’s out of the money, a trader is already taking advantage of earnings-driven elevated option prices and defining risk. The added benefit is that you also give yourself a cushion to be wrong. Let’s go back to our example, if the underlying is trading at $100, you might sell the 95 put. To define your risk, you can buy a lower price put (let’s say you buy the 90 put). You are now short a 95/90 put spread. This has many different names: a bull put spread, a put credit spread, short put vertical, etc.
Benefit of a spread in this case? Even if you’re wrong about the direction for the earnings-driven stock and shares move lower, you’re not necessarily going to have a losing trade. If the underlying sells off to $95.01, and remains at or above this price level at expiration, you’ll still have a potentially profitable trade. The puts will be worth zero at expiration. You were wrong directionally and still made money!
Long or Short?
Although we used the bullish example of selling put spreads, the general idea is the same when it comes to taking a bearish position on an underlying. You might opt to sell a call, which all else equal loses value as the underlying moves lower. Plus you would buy a higher-priced call to define your risk. By selling an out-of-the money call spread, you once again have a cushion for the underlying to move higher following earnings and still potentially have a winning trade.