A company's fundamental backdrop, including anticipated news events like earnings, FDA meetings, or product announcements, typically plays a prominent role in any trader's research. This tends to be true whether one is primarily investing in stocks or in options.
The excitement of event-based trading and the enduring importance of earnings results converge once every quarter as earnings season plays out. Earnings season has the potential to be especially exciting for those option traders looking to take advantage of implied-volatility shifts. One bullish options strategy traders might employ ahead of an earnings report is a bull put spread (selling a higher-strike put and buying a lower-strike put to collect a net credit).
If and when implied volatility is unusually high on the underlying's options, traders might be tempted to sell put spreads in lieu of buying calls. High implieds mean that options are naturally pricier, making premium-selling strategies potentially more attractive than premium-buying ones. There are, of course, important differences between bullishly configured strategies such as long calls and short put spreads.
Hypothetical Example – Selling a Put Spread Ahead of Earnings:
Imagine stock XYZ is days away from its earnings report. The consensus estimate for earnings is 20 cents but a bullish trader believes the actual earnings number will exceed expectations, causing the stock to move higher.
But implied volatility is high, making call options pricey for the option buyer. It would cost $4.50 to buy a short-term, at-the-money XYZ call that might cost closer to $3.00 outside of earnings season.
Instead, the trader decides to sell an at-the-money, 50-strike put with the same expiration month for $3.00 and simultaneously buy an out-of-the-money, 45-strike put for $0.75. This put spread yields a net credit of $2.25.
The goal is for the underlying stock to rise on earnings and for implied volatility to fall, making the put spread cheaper for the investor to buy it to close (at which point he would keep the difference as profit). The maximum profit for selling a put spread is equal to the net premium received. That means no matter how high the underlying stock rises, the most this trade can profit is $2.25. This distinction is important to consider versus the long-call strategy.
If the trader is wrong, and earnings are worse than expectations, the stock price could decline, maybe a lot. In that case, the put spread could end up a loser, if the short put gains in value. With a short put spread, the maximum loss is limited to the difference between the strike prices minus the net credit. In this example, the maximum possible loss is $2.75 per contract. Breakeven is the short put less the credit collected, or $47.75. The maximum loss for a long call is limited to 100% of the premium paid.
If implied volatility does come in after earnings, the value of the call could decline even if XYZ itself moves higher! In this scenario, the put spread could have an advantage over a long call because a drop in implied volatility makes the spread theoretically less expensive to buy it back to close.
Changes in implied volatility and stock price can dramatically impact option pricing, as can the gradual deterioration in time until expiration. The illustration above shows the profit/loss picture of this XYZ spread at expiration. By using tools in a virtual trading account, investors can experiment with how a gain (or loss) in the underlying stock might affect a put spread. Sharp changes in volatility – one way or another – can be plugged in as well in order to gauge how far and how fast an options position might change.
Please refer to Characteristics and Risks of Standardized Options, copies of which can also be obtained by contacting our Customer Service Department at firstname.lastname@example.org.