In a recent segment of CNBC's Fast Money, Cantor Fitzgerald's Mike Khouw offered an options strategy to play The Williams Companies (WMB) ahead of earnings. He suggested buying the March 30 call option at $0.40, arguing that "the option is cheap" and worth betting on the company's earnings.
Where should I begin to describe the wrong thinking here?
First of all, cheap is a relative term. The option is cheap because the stock is cheap. What is cheaper: a $0.40 option on WMB or $4.00 option on Apple (AAPL)? The first one is worth 1.3% of the stock value while the second one 0.8% of the stock value. Which one would you prefer to buy? It depends on many parameters: time to expiration, delta of the option, Implied Volatility etc. The dollar value of the option is not an issue here.
Second, the option is cheap for a reason. This specific option had a delta of 0.35, meaning that it had approximately 35% chance of expiring ITM (In The Money).
Third, cheap or not cheap, if you are wrong, you can still lose 100% of your investment. The stock was trading around $29.40 at the time of the recommendation.
The day after the earnings, the stock is down 2%. The 30 call is down 70%. Ouch.
Let's take another example. Before the last JPMorgan (JPM) earnings, the "Fast Money" experts recommended the 36/37.5 bull call spread (buy 36 call/sell 37.5 call) at 0.40 debit. The stock was trading around 35.50 at that time. This is a $1.50 spread, so your maximum gain is 1.10. You risk $40 to make $110, or 1:3 risk/reward. The Fast Money "experts" defined it as a "high probability" trade.
You don't have to be a rocket scientist to understand that "high risk/high reward" and "high probability" don't belong in the same sentence. Based on the deltas of the strikes, that trade had about 35% probability to break even. This is normal. For example, if you pay $2.00 on a $10 spread, you have about 1:4 risk reward but only 20% probability of success. When you pay $8.00 on the same spread, your probability of success is about 80%, but risk/reward is terrible. The risk/reward and the probability of success have reverse correlation when it comes to options.
There no free lunches in the stock market. The "high probability" definition of that trade was completely false, misleading and unprofessional.
So what are the lessons from those two examples?
First, when it comes to earnings, never bet on direction with options. Doing that is a pure gambling. If you are wrong about the direction, you can lose 50-100% of your investment. If you are right but the move is not large enough, you can still lose money due to Implied Volatility) collapse. Even for a stock like Apple which was a stellar performer in the last few years, buying calls just before earnings would produce and average loss of 20%, like I showed in my article 'Whatever You Do, Don't Do This Before Apple's Earnings. For Amazon (AMZN), this strategy would produce a 31% loss.
In my opinion, when Fast Money recommends on national television gambling on earnings with directional trades, it is highly irresponsible and unprofessional. It might work sometimes, and I'm sure they will mention those few successful trades. But the odds are against you, and your chances of 50-100% loss are very significant.
My favorite way to play earnings is buying a straddle or a strangle a few days before the announcement to take advantage of the rising IV of the options before the earnings. I will sell just before the numbers are released when the IV has peaked and NOT hold through earnings. I described the general concept in my article "Exploiting Earnings Associated Rising Volatility." The strategy performed very well so far. Check out, for example, how this strategy made 20% in two trading days on Amazon while the stock was unchanged.
I'm not looking for home runs here (although I had few when IV spiked), but consistent 10-15% gains with relatively low risk. You can see the YTD performance of this strategy here. Allocating 10% per trade would produce a 15% gain on the overall portfolio in less than two months with very low risk.