Many investors tend to avoid trading through earnings season simply because stocks can make unpredictable moves. However, avoiding these unpredictable moves is a huge missed opportunity.
The problem most investors run into is they simply don’t know how to structure the right kind of trade to take advantage of a modest move. The most common “non-directional” trade is a long straddle or strangle.
The long straddle is often used as a strategy to trade earnings when you believe a stock will move … but you’re not sure which direction. By buying a call and a put at the same strike price, with the same expiration date, you hope to earn more on the winning side of the trade than you lose on the other side.
The long strangle is a similar strategy, but one in which the strike prices are different. You’re still buying a call and a put that have the same expiration dates. But the call you buy would have a higher strike price than the put you buy. This strangle may appeal more than the straddle because it should be just a little cheaper to enter.
A Better Way to Trade Earnings With Options
While it is true that long straddles and strangles can make money no matter which direction the stock moves, neither strategy is a good fit for earnings because they become very expensive to buy prior to the report.
Take a look at what happened with Google (NASDAQ:GOOG). The straddle on GOOG before it reported earnings cost over $35, with only one day until expiration! This is because the implied volatility on the options was around 120%, making them very expensive. (That’s $3,500 a contract!)
Basically, after you’ve spent $35 a share to trade the straddle, you need the stock to make a move that’s bigger than what you’ve spent to recoup your capital on the trade. Rather than betting GOOG will make a $35+ move over earnings in order to show a profit, it is better to bet on a much smaller move to make your gains.
Wouldn’t You Rather Get Paid to Trade Earnings?
A simple twist on a common income strategy makes for a great “hold over earnings” trade. The long butterfly — where you sell two at-the-money options and buy one out-of-the-money option and one in-the-money option — is a trade many investors use to benefit from time decay.
The time decay is compounded by the weekly options’ always-fast-approaching expiration date. (So, you won’t be seeing $35-a-share prices like Google’s on the day before expiration!)
We’ve talked about long strategies so far with the straddle, strangle and butterfly. There are also short strategies that give you income. Now, you’d take on an incredible amount of risk doing a short straddle or strangle. But a short butterfly — buying two at-the-money options and selling one in-the-money option and one out-of-the-money option — is actually a fairly conservative strategy … and one that can work for you.
By taking the short side of the butterfly, you can benefit from a much smaller move in the stock, without having to put excessively large amounts of capital on the table. I am doing the following trade now on Caterpillar (NYSE:CAT) going into and most likely holding over earnings.
Trade #1 — Caterpillar
With the last two earnings reports on Caterpillar (NYSE:CAT), the stock moved $4 and $7, putting the odds in our favor that this trade will make money over earnings, if not sooner.
With CAT trading at about $105 I am structuring the following position:
- Selling 10 $100-strike calls for Jan. 27 expiration
- Buying 20 $105-strike calls for Jan. 27 expiration
- Selling 10 $110-strike calls for Jan. 27 expiration
This position can be done for a $1.60 credit. Therefore, it doesn’t matter exactly what you pay or collect for each option, as long as you end up with a net credit of $1.60 ($160 a contract) in your pocket.
This trade makes money from a $3.50 move in either direction over earnings (or even prior to earnings).
Three other stocks are presenting the same opportunity that you can take advantage of. Let’s take a look at them now.
Trade #2 — Netflix
You’ll note on the CAT trade that we used strike prices that were $5 apart ($100, $105, $110). In Netflix (NASDAQ:NFLX), you may want to stick with that $5 spacing.
But if you’re looking for a bigger move, which I am in NFLX, you can also consider spacing out the strikes by $10. ($10 takes on more risk but may yield a bigger reward.)
Here is the more-conservative way to play this trade:
- Selling 10 $90-strike call for Jan. 27 expiration
- Buying 20 $95-strike calls for Jan. 27 expiration
- Selling 10 $100-strike calls for Jan. 27 expiration
Or you can try it this way:
- Selling 10 $85-strike call for Jan. 27 expiration
- Buying 20 $95-strike calls for Jan. 27 expiration
- Selling 10 $105-strike calls for Jan. 27 expiration
Trade #3 — Amazon
I will be doing the same on Amazon.com (NASDAQ:AMZN), but I need to wait until the new weekly options come out on Thursday, Jan. 26 in order to structure a position that I can hold over earnings that will be reported on Jan. 31 after the closing bell.
Here’s what this trade entails:
- Selling 10 $10 in-the-money strike call for Feb. 3 expiration
- Buying 20 at-the-money strike calls for Feb. 3 expiration
- Selling 10 $10 out-of-the-money strike calls for Feb. 3 expiration
As of this writing, the $185 strike is the at-the-money option. So that’s the “body” of your butterfly, and you would buy 20 of those. Then that means you’d also sell 10 of the $175 calls and sell 10 of the $195 calls. (Be sure to adjust the strikes to fit the stock price when you enter the trade.)
Trade #4 — Baidu
What you did with the Amazon trade, you can also do with Baidu (NASDAQ:BIDU), which is reporting earnings on Jan. 30 after the close.
Here’s the setup:
- Selling 10 $10 in-the-money strike calls for Feb. 3 expiration
- Buying 20 at-the-money strike calls for Feb. 3 expiration
- Selling 10 $10 out-of-the-money strike calls for Feb. 3 expiration
With the $120 strike currently the one that’s at-the-money, you’d buy 20 of those and then sell 10 of the $110 calls and sell 10 of the $130 calls to make the butterfly take flight.
I would also consider shrinking the spacing between the strikes down to $5 on BIDU. The reward may be a little less, but your risk also decreases along with it.
To learn more about Karson Keith’s weekly options strategies, click here.
