The earnings season is approaching fast. There are many ways to play earnings. Some people would bet on the direction of the stock movement after the announcement and buy or short the stock. Others will buy call or put options. My opinion is that predicting the market reaction to earnings is an extremely difficult task. In case of Google, the options expiration is usually the next day after the announcement, so if you are wrong, you are likely to experience a 100% loss.
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. This works well on higher priced stocks like Google (NASDAQ:GOOG), Apple (NASDAQ:AAPL) or Amazon (NASDAQ:AMZN).
The strategy produced a 140% return so far in 2012 for me and my subscribers. 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.
Google is one of my favorite stocks for this strategy. I played Google three times in the last cycle, gaining 12-15% each time.
Google hasn't set the earnings date yet, but the company usually reports on the last Thursday on the options cycle which is October 18, 2012. Three weeks before expiration, with Google trading around $756, I placed the following Reverse Iron Condor trade:
- Sell to open GOOG October 19 2012 710 put
- Buy to open GOOG October 19 2012 720 put
- Buy to open GOOG October 19 2012 800 call
- Sell to open GOOG October 19 2012 810 call
Price: $4.70 debit. Some of my subscribers were able to pay lower price.
How do we make money on this trade?
The main idea behind the trade is renting the options before the earnings. An increase in IV should help to neutralize the negative theta and keep the floor under the trade 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. If the stock moves (and Google tends to be fairly volatile before earnings), the trade should make money as well.
What is the risk?
The main and only risk of the trade is the negative theta (time decay). 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.
How do we manage the trade?
The trade should be watched closely - however, it cannot lose 20-30% overnight like some other strategies. The theta loss is very gradual, and even if the IV increase is not enough to offset the theta, we are not likely to lose more than 2-3% per day. I will close the trade if it loses around 20%. My profit target is 15-20%. If the stock moves $30-35, I will likely to close the trade and re-open with new strikes. The goal is to be as delta neutral as possible.
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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I'm long the Iron Condor trade mentioned in the article.