by Tyler Craig | January 16, 2014 1:54 pm
Before you panic, don’t worry — Twitter (TWTR) is not the next Best Buy (BBY). Instead, it’s the perfect trading bait to help illustrate an options strategy that can protect you the next time a stock … well, does what Best Buy did today.
With earnings season well underway, traders are once again being reminded of the dangers of holding a stock into an earnings announcement. While there is a chance that your stock will surge in response to stellar earnings, there’s an equally likely chance it will plummet if the numbers don’t measure up to the Street’s often fickle expectations. A rogue earnings announcement can throw a wrench into even the best laid out plans.
Best Buy was the latest casualty in this year’s first installment of the earnings game. The ailing retailer is down more than 27% today after disappointing investors with their holiday sales. And don’t think BBY stock will be the only victim by the time earnings season winds down. I assure you there will be a other stocks taken to the woodshed after failing to live up to Wall Street’s expectation.
Fortunately, there’s a very simple — and often free — way to protect your stock position into earnings. The strategy of which I speak is affectionately known by options traders as the option collar. To enter the position, you simply sell one out-of-the-money call option and buy one out-of-the-money put option in the same expiration month for every 100 shares of stock you own.
Let’s use the world’s most beloved social media stock — Twitter — to illustrate.
The Twitter earnings report — the company’s first announcement as a publicly traded entity — is slated for Feb. 5, a short three weeks away. With TWTR stock almost doubling from its post-IPO lows, it’s fair to say expectations on the blue bird are quite high. These lofty expectations could be setting the stock up for quite the volatile post-earnings reaction.
To protect against an outsized drop in TWTR stock, shareholders can purchase a collar using February weekly options expiring on Feb. 7 (two days after earnings). With the stock trading for $62 you could sell the Feb 62.50 strike call for $5.75 and buy the Feb 61.50 put for $5.75. Since the premium received from the short call is sufficient to pay for the long put, the collar can be entered for no cost (not counting commission, of course).
The short 62.50 call obligates you to sell TWTR stock should it rise above $62.50, which, on a side note, is the primary drawback of the collar. However, the long 61.50 put gives you the right to sell TWTR stock at $61.50, which limits your potential loss to a mere 50 cents per share ($62 – $61.50). With your potential profit and loss so limited, you’ve insulated the position from any type of volatile reaction following TWTR stock’s earnings announcement.
The difference between the risk and reward associated with a long stock position versus a collar are easily seen within a risk graph. Take note of both graphs shown below.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
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