By Greg Jensen
Earnings season is worrying for investors at the best of times. This time around, following a string of downward revisions in estimates from analysts, it seems doubly so. Most investors suffer more anguish from taking losses than they get pleasure from taking profits. If you find the stress of earnings season too much, there is a fairly simple options strategy that could give you some peace of mind; a zero cost collar.
The basic trade is fairly simple. The owner of a stock buys a put (an option to sell) to insure themselves against a collapse in price after a bad earnings report. They pay for this by selling a call (an option to buy) on the same stock. Let’s look at a couple of examples.
If you own Facebook (FB), you would probably be right to be a little nervous about next week’s earnings release. Given the questions about the company’s ability to monetize their product, any weakness in the numbers will likely be badly received. At the time of writing FB is trading at around $20. You could protect against the stock price falling dramatically by buying November $18 puts at a cost of $0.70 per share. (If you are new to options, you should know that they are traded in contracts of 100 shares, so one contract would cost $70.00). You could pay for this by selling November $22 calls at $0.70 per share.*
Netflix (NFLX) is another widely followed company that will report next week. If you own that stock, the same strategy can be applied. NFLX is trading at around $68.50. November $82.00 calls can be sold for $2.00 per share, funding a purchase of November $57.50 puts, which last traded at $1.96.*
On the surface, these strategies would seem to give you protection for free, but, as we all know, there is no such thing as a free lunch. Firstly, you will have to pay commission on the trades. Online options trading platforms offer low rates that make this much less of a concern than in the past, however. Secondly, you are paying for your insurance by giving up an opportunity. Should the release be hugely positive, your gains from the current level are capped at the strike price of the calls you sold. In fact it may well be less than that, as you may want to close out your position in the puts for a loss.
As with any trade, timing is very important. In both of these cases the stock is up on the day as I write. This means that the calls which you are selling will receive a higher price and the puts that you buy will be cheaper, due to the stock’s upward momentum. If the stock you own doesn’t have any days of gains in the few weeks preceding earnings, then you may be wise to just sell it!
If you find yourself waking up in a cold sweat as earnings release day approaches, there may be a cure. A zero cost collar is a basic strategy, but it illustrates that options need not be scary, and can be useful to an investor as well as a trader.
*Both examples are for illustrative purposes only. The prices quoted are based on the close as of 10/17/2012.
For more information on options, go to Option Animal's website