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In this article, I will describe some of my favorite ways to trade earnings for companies reporting during the week of May 28-31, 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 with 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. It produced a 52% ROI YTD. 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 No. 1: Lions Gate Entertainment (NYSE:LGF)

Lions Gate reports earnings on Wednesday, May 30, 2012, after the market close. With the stock currently around $12.95, I'm looking at the following trade:

  • Buy LGF June 2012 13.0 put
  • Buy LGF June 2012 13.0 call

Trade No. 2: Ciena (NYSE:CIEN)

Ciena reports earnings on Thursday, May 31, 2012, before the market open. With the stock currently around $11.95, I'm looking at the following trade:

  • Buy CIEN June 2012 12.0 put
  • Buy CIEN June 2012 12.0 call

Trade No. 3: Joy Global (NYSE:JOY)

Joy Global reports earnings on Thursday, May 31, 2012, before the market open. With the stock currently around $60.15, I'm looking at the following trade:

  • Buy JOY June 2012 60.0 put
  • Buy JOY June 2012 60.0 call

Trade No. 4: OmniVision (NASDAQ:OVTI)

OmniVision reports earnings on Thursday, May 31, 2012, after the market close. With the stock currently around $14.15, I'm looking at the following trade:

  • Buy OVTI June 2012 14.0 put
  • Buy OVTI June 2012 14.0 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:

  1. 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.
  2. 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 three to five days.
  3. 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.
  4. 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.

Please trade responsibly. Invest only what you can afford to lose. If the stock moves before earnings and you decide to execute one of those trades, please adjust the strikes accordingly. Look at this list as a starting point for your research.

Disclosure: I will be initiating some of the above-mentioned positions in the next 72 hours.

Source: 4 Earnings Plays For The Week Of May 28-31