Options are one way advanced traders can get directional exposure in a stock
Around earnings time, an option that may typically be inexpensive can cost substantially more
Selling an option spread can give you directional exposure, defined risk, and potentially, a lower buying power requirement
Earnings season: It’s pageant time for the companies that you’re familiar with, and whose products you possibly consume daily. It’s a bustling time for potential market-moving news and a good time to get familiar with streamlined trading tools, including Order Entry on the thinkorswim® platform.
Figure 1 (below) shows some of the platform features that allow traders to put on option spreads and other multi-leg option trades in a few steps. But first, let’s cover why multi-leg trades, or option spreads, might make sense for some qualified option traders in their approach to earnings season.
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For shareholders, earnings season is an opportunity to see if a company’s management has been a good steward of your investment. For others, earnings, revenue, and forward-looking guidance could provide potential inspiration for a new position. Regardless of the reason behind your active interest, you may find yourself thinking: “If I had the money, I would (buy/short) shares of company XYZ.” Is there a way to speculate on the post-earnings move without the upfront capital that a straight stock trade might require? If the company’s stock is publicly traded and has options, the answer is yes for options-approved traders.
Let’s say your target stock currently trades for $100 and you feel strongly that it could head higher.
- Challenge one: Buying 100 shares will cost you $10,000. Options give you an alternative way to take a position on your hunch for the stock move after earnings, but typically at a fraction of the cost. Buying a call option (the right but not the obligation to purchase the underlying stock at a future, set price and time) may be the first thing that comes to mind when taking a bullish stock position via options. Challenge two: Around earnings time, an option that may typically be inexpensive can cost substantially more. In addition to increased costs, traders have now pushed their breakeven level higher.
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But who says you have to be the buyer in this little scenario? Perhaps there can be some benefit to selling the high-priced options? Ask yourself: if calls gain value as a stock moves higher, is there something else that loses value? Everything else being equal, a put option (the right but not the obligation to sell the underlying stock at a future, set price) loses value as the underlying instrument moves higher. It would follow that selling puts on a company could be a useful tool in playing an upside hunch following earnings.
So, we’ve already talked about how expensive purchasing shares outright can be. Someone may rightly point out that selling puts can also come with a “high buying power requirement,” meaning, for some accounts, the buying power needed to sell a put can be equally as prohibitive as purchasing shares. One alternative might be to buy a put at a lower strike price than the one you’re thinking about selling. Doing so can help you define your risk. Selling a naked put—meaning that you don’t own the underlying shares—gives you risk all the way down to zero, and thus a high buying power requirement. However, selling a put option spread—a strategy that involves buying and selling equal numbers of put contracts simultaneously—can come with a significantly lower buying power requirement. You’re still taking a speculative position on the underlying company of your choice, but not betting the farm. Keep in mind that spread strategies can also entail substantial transaction costs, including multiple commissions, which may impact any potential return.
FIGURE 1: ORDER ENTRY: HOW TO GET THERE. Log in to your account and launch the thinkorswim platform. Select the Trade tab and enter the stock ticker (symbol) in the top left box. An option chain of available strike prices will pop up. Right-click anywhere on the option price chain of your selected series to bring up the order menu. Then select Sell (or Buy) and choose from the spread selections displayed in the pop-up menu (Vertical in our example). An order box will pop up, allowing you to confirm and send your trade. For illustrative purposes only.
What If I’m Wrong?
By selling a put spread that’s out of the money, this strategy is already taking advantage of earnings-driven elevated option prices and defined risk. The added benefit is that it also provides a cushion to be wrong. Let’s go back to our example. If the underlying is trading at $100, you might sell the 95-strike put. To define your risk, you can buy a lower-price put (let’s say you buy the 90-strike put). You’re now short a 95/90 put spread. This has many different names: a bull put spread, a put credit spread, or a short put vertical spread.
The benefit of a spread in this case? Even if you’re wrong about the direction for the earnings-driven stock, and shares move lower, you’re not necessarily going to have a losing trade. If the underlying sells off to $95.01, and remains at or above this price level at expiration, you’ll still have a potentially profitable trade. Both of the puts would be worth zero at expiration. In this example, you were wrong directionally, but still made money.
Of course, the risk is if the stock breaks below $95. You would incur the maximum loss if the stock goes below $90 at or before expiration. In this case, your maximum loss would be the difference between the strikes ($5), minus the credit you received from selling the put spread (plus transaction costs).
Long or Short?
Although we used the bullish example of selling put spreads, the general idea is the same when it comes to taking a bearish position on an underlying. You might opt to sell a call, which (all else equal) loses value as the underlying moves lower. Plus, you would buy a higher-priced call to define your risk. By selling an out-of-the money call spread, you once again have a cushion for the underlying to move higher following earnings and still potentially have a winning trade.