To the average investor, earnings announcements may seem like manna from heaven — a godsend designed to provide instant outsized profits.
That attitude can be understandable. It’s not uncommon to see stocks explode higher and generate huge gains for stock and options traders in a single day following their quarterly release.
Take Google (NASDAQ:GOOG) for instance. In response to its last two earnings releases, it was up a quick 13% and 7%, respectively.
One huge challenge with trying to play the earnings game, without a game plan, is the fact that a large portion of the so-called manna is laced with arsenic. Many earnings announcements are downright toxic and can result in instant losses of epic proportions. Just ask any Netflix (NASDAQ:NFLX) junkie who held into the October 2011 announcement that resulted in a 37% gap down.
Over time as earnings seasons come and go, one overriding truth becomes apparent — earnings announcements are better left to the gamblers. And if you have stock positions that could be vulnerable to news, your time (and money) may be better spent protecting those than chasing after new potential gains.
Fortunately, shareholders can sidestep the earnings drama by utilizing the risk-reducing nature of the options market. The ironclad collar strategy affords you the ability to use options to protect your stock positions, going into earnings season.
The collar strategy is easy and, best of all, it’s an inexpensive way to buy some peace of mind. To initiate a collar, stock owners sell an out-of-the-money call option while simultaneously buying an out-of-the-money put option in the same expiration month.
With the collar in place, you can enter earnings with defined risk to the downside. There is limited reward to the upside, but it is only temporary and you can remove your collar if and when the stock breaks out to the upside.
Suppose you own 100 shares of Goldman Sachs (NYSE:GS), which is currently trading for $98.50 and is slated to report earnings on Jan. 18. To enter a collar you could “sell to open” the GS Feb 100 Call for $4.15 while “buying to open” the GS Feb 95 Put for $3.35. At current prices, you would receive a credit of 80 cents ($80 per contract) to initiate the collar.
The risk graph below displays the collar position. Read on to see how this protective collar strategy works.
Source: MachTrader
By purchasing the GS Feb 95 Put, you acquire the right to sell your shares at $95. That limits your downside risk to $3.50 ($98.50 – $95) minus the 80 cents received from entering the collar, or $2.70.
By selling the GS Feb 100 Call against your long shares, you obligate yourself to sell the stock at $100. That limits your profit potential to $1.50 ($100 – $98.50) plus the 80 cents received from entering the collar, for a total of $2.40.
Regardless of what surprises may be in store following Goldman’s earnings announcement, the collar generates surefire protection.
At the time of this writing Tyler Craig had no positions on GS.
