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A Safer Way to Play Earnings With Options

July 01, 2012 | Comments: 0 | Views: 154

There are many ways to play earnings. Some people prefer to play them directionally, buying calls or puts. I think that earnings are unpredictable; hence I prefer to play them non-directionally.

When you trade options, your goal can be maximizing your profits or limiting your losses. Usually, you cannot have both. Using the first approach, you will have some homeruns but also some big losers. Using the second approach, you might have less homeruns, but your losses will be limited as well.

It's a matter of personal style. I personally prefer the second approach. I had more 100% losers than I would like to admit before I decided to adapt the Risk Averse approach.

This is the reason why I don't like holding any trades through earnings. The risk is just too big, at least for me. Some people like to have some homeruns and don't mind losing 100% from time to time. Not me.

My favorite way to play earnings is to buy straddle (or a strangle) a few days before earnings and sell it just before earnings are announced (or as soon as the trade produces a sufficient profit). The idea is to take advantage of the rising implied volatility (IV) of the options before the earnings.

Over time, the options tend to overprice the potential move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move.

Jeff Augen, a successful options trader and author of six books, agrees:

"There are many examples of extraordinary large earnings-related price spikes that are not reflected in pre-announcement prices. Unfortunately, there is no reliable method for predicting such an event. The opposite case is much more common - pre-earnings option prices tend to exaggerate the risk by anticipating the largest possible spike."

Under normal conditions, a strangle trade requires a big and quick move in the underlying. If the move doesn't happen, the negative theta will kill the trade. In case of the pre-earnings strangle, the negative theta is neutralized, at least partially, by increasing IV. In some cases, the theta is larger than the IV increase and the trade is a loser. However, the losses in most cases are relatively small. Typical loss is around 10-15%, in some rare cases it might reach 25-30%. But the winners far outpace the losers and the strategy is overall profitable.

Market environment also plays a role in the strategy performance. The strategy performs the best in a volatile environment when stocks move a lot. If none of the stocks move, most of the trades would be around breakeven or small losers. Fortunately, over time, stocks do move. In fact, big chunk of the gains come from stock movement and not IV increases. The IV increase just helps the trade not to lose in case the stock doesn't move.

I play a lot of those earnings plays in my educational forum SteadyOptions.

Kim Klaiman is an active options trader and founder of SteadyOptions. He trades mostly non-directional strategies, like pre-earnings strangles and iron condors. Likes to trade strategies with negative correlation. He lives in Toronto, Canada.

Visit my educational blog http://steadyoptions.com/.

Source: EzineArticles
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