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How to Trade Options Before Earnings or News Release
Like a sexy gal that can cook or an inside source at the racetrack, an actionable option strategy prior to an earnings release is something that traders know must be out there, yet it remains elusive. Most investors looking to capitalize on an earnings beat or miss simply buy calls or puts. Some of the more sophisticated speculators even get long both a call and a put (straddle/strangle), thinking that if the stock moves enough one way or the other, they'll come out at least a little bit ahead.
Limited Risk – High Reward
The allure of only being long calls and/or puts is that a trader knows their maximum risk as soon as they enter the order. If a call on Apple costs $100, then $100 is the most you can lose, plus you have the chance to "rake it in" if Apple moves significantly before the option expires.
Therein lies the trouble with most long-side option strategies prior to earnings announcements...since no one knows what the earnings report will hold, or how the underlying stock will react; the demand for options goes up markedly before the announcement. Both speculators and shareholders looking to insure against volatility are clamoring for options which dramatically increases the premiums, making puts and calls overpriced.
Being the Bookie
Everyone knows that taking bets is more profitable long-term than making bets. Especially if the wager has very favorable odds for the house. This is exactly what overpriced options are for the seller – a game that stacks the deck against the buyer. In general, immediately after earnings are released, the demand for - as well as the volatility premium built into - calls and puts, evaporates. Even those that theoretically have both upside and downside covered find it difficult to profit once that "premium of the unknown" is gone from their asset.
So the obvious solution would appear to be: become a seller of options. If only it were that easy! Unless you have the bottomless pockets of a Goldman Sachs, the unlimited risk part of being a naked option seller will be too much for you and your broker's heart to take.
In order to take advantage of the inflated premiums in the option market prior to an earnings announcement, yet mitigate the risk of selling uncovered (naked) puts/calls, the go to strategies are "bull put credit" and "bear call credit" spreads.
Rather than getting bogged down in the stock XYZ trading at $50 - type explanation, I'll leave it to a google search for those wanting the nuts and bolts of how to construct the option spreads mentioned above. The focus here is how to maximize the profit from these spreads and that is accomplished in the unwinding.
Once the earnings report comes out and the market is digesting and reacting to the numbers, option prices revert to a more realistic reflection of future prospects.
This allows the options trader to unwind his pre-earnings position and cash in on the uncertainty
that was prevelant prior to the announcement. Does it work every time? No. Does it provide enough profit to get an address on easy street if it's all a trader does? No. But it works often enough and provides a boost to the bottom line to make it a worthwhile play to investigate further.
Updated on 11/1/2016.