Earnings season is just around the corner. If you think that you can predict the results of the upcoming earnings, you can just buy/sell the stock or calls/puts ahead of earnings. In my opinion, earnings are 50/50. I prefer not to take any directional risk.
My favorite way to play earnings is buying a strangle a few days before earnings and selling 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 IV (implied volatility) of the options before the earnings. (I described the general concept here.) Next week, two big banks will be reporting their earnings.
The stock is currently trading at $29.05. The suggested trade is:
- Buy C January 2012 $29.00 put
- Buy C January 2012 $29.00 call
The current cost of the trade is $1.95. The negative theta of the trade is currently about 4.0%. That means that, all other factors equal, the trade will be losing 4.0% per day. However, I expect the rising IV to offset the negative theta at least partially.
The stock is currently trading at $28.94. The suggested trade is:
- Buy WFC January 2012 $29.00 put
- Buy WFC January 2012 $29.00 call
The current cost of the trade is $1.46. The negative theta of the trade is currently about 4.2%. That means that, all other factors equal, the trade will be losing 4.2% per day. However, I expect the rising IV to offset the negative theta at least partially.
Please note that I'm using a straddle (same strikes) and not a strangle for those trades because both stocks are trading near the strike price and placing a strangle would be too commission-consuming. In addition, being so close to expiration the strangle will have much higher negative theta.
You might notice that with almost identical stock price, the cost of the WFC trade is significantly lower. The explanation is lower IV of WFC options - 35% compared to 46% for C options.
Due to the high negative theta of the trades, I recommend placing both trades only 1-2 days before the earnings, i.e. this Thursday or Friday. You need to exit the trade on Monday, January 16 before the market close. If we get the IV increase and even moderate movement of the stock, the trade can deliver 25-30% gains. Worst case scenario I don't expect to lose more than 7-10% due to the short holding period.
The main idea behind those trade is "renting the strangle or the straddle" before the earnings. An increase in IV should help to neutralize the negative theta and keep the floor under the strangle price. If the stock moves, it should help to increase the gains. In case of those two stocks, I don't expect a dramatic IV increase, so we should hope that the stock moves during our holding period.
As we know, earnings are 50/50. This is a trade for those who don't want to bet on the direction of the stock and don't want to hold through earnings.