In this article, I will describe some of my favorite ways to trade earnings for companies reporting during the week of May 1-4, 2012.
My regular readers already know that 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 Implied Volatility (IV) of the options before the earnings. I described the general concept here. In general, I look for companies having a history of big post-earnings price moves. Those big moves will cause the IV to spike before earnings.
In some cases I will buy an Out-of-The-Money (OTM) strangle and sell a further OTM strangle, creating a Reverse Iron Condor.
The strategy performed well so far this year, despite a low IV environment. 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 2012 performance here.
So here is the list of next week's candidates in chronological order:
Trade #1: Archer Daniels Midland (ADM)
ADM reports earnings on Tuesday, May 1, 2012, before the market open. With the stock currently around $31, I'm looking at the following trade:
Buy ADM May 2012 31.0 put
Buy ADM May 2012 31.0 call
Trade #2: Cummins (CMI)
Cummins reports earnings on Tuesday, May 1, 2012, after the market close. With the stock currently around $115.10, I'm looking at the following trade:
- Sell CMI May 2012 105.0 put
- Buy CMI May 2012 110.0 put
- Buy CMI May 2012 120.0 call
- Sell CMI May 2012 125.0 call
Trade #3: MasterCard (MA)
MasterCard reports earnings on Wednesday, May 2, 2012, before the market open. With the stock currently around $445, I'm looking at the following trade:
Sell MA May Week1 2012 425.0 put
Buy MA May Week1 2012 430.0 put
Buy MA May Week1 2012 460.0 call
Sell MA May Week1 2012 465.0 call
Trade #4: Green Mountain Coffee Roasters (GMCR)
GMCR reports earnings on Wednesday, May 2, 2012, after the market close. With the stock currently around $46.20, I'm looking at the following trade:
Buy GMCR May Week4 2012 46.0 put
Buy GMCR May Week4 2012 46.0 call
Trade #5: JDS Uniphase (JDSU)
JDSU reports earnings on Wednesday, May 2, 2012, after the market close. With the stock currently around $12.70, I'm looking at the following trade:
Buy JDSU May 2012 13.0 put
Buy JDSU May 2012 13.0 call
Trade #6: Linkedin (LNKD)
Linkedin reports earnings on Thursday, May 3, 2012, after the market close. With the stock currently around $102.60, I'm looking at the following trade:
- Sell LNKD May Week1 2012 90.0 put
Buy LNKD May Week1 2012 95.0 put
Buy LNKD May Week1 2012 110.0 call
Sell LNKD May Week1 2012 115.0 call
Trade #7: CF Industries (CF)
CF reports earnings on Friday, May 4, 2012, before the market open. With the stock currently around $192.50, I'm looking at the following trade:
Sell CF May Week1 2012 180.0 put
Buy CF May Week1 2012 185.0 put
Buy CF May Week1 2012 200.0 call
Sell CF May Week1 2012 205.0 call
The main idea behind those trades is "renting the strangle/straddle" (or the reverse Iron Condor) before the earnings. An increase in IV should help to neutralize the negative theta and keep the floor under the strangle price. 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.
Some additional considerations for all trades:
The main and only risk of those trades is the negative theta (time decay). Some of the trades are using options that expire in just few days so the theta is fairly large. The expectation is that an increase in IV will offset the theta, but it doesn't always happen. If the stock moves, it will help. In any case, you can control your loss since theta damage is gradual. It is very unusual to lose more than 10-15% on those trades.
If you don't want to place the Reverse Iron Condor, you can do the trade with the strangle or straddle. The trade will be more expensive and the negative theta much higher, so I recommend to be in the trade no more than 3-5 days.
Choice of strikes depends on your risk tolerance. Risk and reward are always closely related. Going far out of the money will gain more if the stock has a decent move. Going near the money will gain less with less risk. I usually like strikes with deltas in the 25-30 range, which is a good compromise in my opinion. My article "Google Earnings Trade: Risk Vs. Reward" has a good discussion on the choice of strikes.
Instead of weeklies, you can choose a more distant expiration to reduce the effect of the negative theta. However, the IV increase for the distant expiration will be less as well. The IV is the most inflated for the options with closest expiration.
The prices might be different when you place the trade so adjust the strikes accordingly.
Disclosure: I will be initiating some of those trades in the next 72 hours.