W. Edward Olmstead's  Instablog

For those of you who have been following our FB earnings protection trade, the moment of truth is upon us, with the company issuing its report after the close tomorrow (1/30).

Going back to last Friday (1/25), those who had entered our suggested trade were faced with a decision. With FB stock traing around $31.50, the expiring short weekly Jan 30 call was in-the money and a decision had to be made to either (i) allow your stock to be called away for $30 per share plus the $.70 per share collected from selling the weekly Jan 30 call and weekly Jan 26 put. You could still continue holding the Jan 27 put that expires this week in anticipation of a stock price pullback following the earnings report, or (ii) buy back the in-the-money Jan 30 call for a net cost of $0.80 per share in order to hold the stock through the earnings report. Again, the Jan 27 put would be in place to insure a minimum sale price of $27 per share through this Friday (2/1). Either decision would leave you well placed in the event of an earnings disaster such as that recently observed when Apple Inc (AAPL) issued a disappointing report.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

For those of you who have been following the FB trade that was proposed in my previous Seeking Alpha articles and blog entry of 8/15/12, the residual option position is now showing a profit of 76%. Since the residual position includes the long Jan 16 call that will be expiring this Friday (1/18/13), a decision needs to be made. The basic choices are: (i) sell the Jan 16 call and collect the profit, (ii) exercise the call to become the owner of 100 shares of FB stock at a price of $16 per share. (iii) roll the Jan 16 call into a later month.

If you wish to continue participating in the price movement of FB, choice (iii) provides that opportunity without the need for extra capital to purchase the stock. Even after choosing (iii), there are further selections to be made in terms of which expiration month and which strike price should be used.

Rolling the Jan 16 call into a June call option will provide for another five months of participation in the FB price movement. Here are a couple of possibilities involving June options : (iii-a) Roll the Jan 16 call into the Jun 17 call for a small profit that will cover your commission costs. The Jun 17 call has a delta of 0.96, which means that this option will capture essentially all of the price movement of the stock. (iii-b) Roll the Jan 16 call into the Jun 23 call, which will produce enough profit to cover the cost of your Jan 16 call and thus represents a free trade for the next five months. The Jun 23 call has a delta of 0.83, which will also mimic the price movement of the stock quite well.

Now that many stocks have weekly options, there are new strategies available to protect the price of a stock following an earnings report. Stocks often experience their biggest declines in price after an earnings report fails to meet the expectations of investors. Weekly options can offer cheap, short-term insurance to lock in a minimum sale price of a stock that is vulnerable to an earnings setback.

It has always been possible to use monthly put options to protect the price of a stock through the date of the company's earnings report. The problem with monthly puts is that they can be quite expensive, particularly when the expiration date is substantially later than the earnings report. Weekly options are cheaper and offer more flexibility in providing short-term protection.

Not all stocks have weekly options, but when they are available, it is prudent to know how to employ them to circumvent an earnings report disaster. A timely illustration of a protective options strategy will be presented for Facebook Inc (FB), which has its next earnings report on January 30, 2013.

FB stock is currently trading around $28, which represents a nice 40% increase since mid-November. With the company's earnings report scheduled for January 30, there is concern about losing those recent gains if the report is less than spectacular. Let's explore an inexpensive strategy to protect the price of FB by using a combination of weekly options.

This protective strategy assumes the ownership of 100 shares of FB stock. While this trade may be appropriate for the protection of FB stock purchased at any price, it is designed primarily for stock purchased below the level of $27 per share.

It is easiest to present this protective strategy as a combination of two separate trades. The first trade is the purchase of a weekly put that expires two days after the FB earnings report. For 100 shares of FB stock, buy one contract of the Feb 27 put that has an expiration date of February 1. The current cost of this put is $1.25 per share. This put will allow you to liquidate your stock for $27 per share if the earnings report on January 30 leads to a collapse of the FB stock price.

The second part of the strategy is intended to lower the cost basis of the long Feb 27 put. In this second trade, sell one contract of the Jan 30 call and one contract of the Jan 26 put, each of which expires on January 25. Currently, the premium received from the sale of these two options is $.70 per share. This sale will reduce the cost basis of the long put from $1.25 per share down to $.55 per share.

The recent price range of FB stock will likely hold for the next few weeks leading up to the earnings report on January 30. This suggests that the short Jan 30 call and short Jan 26 put will expire worthless on January 25, five days before the earnings report. The residual option position will be long one Feb 27 put with a cost basis of $.55 per share that is valid through the week of January 28 -February 1. With the FB earnings report on January 30, there will be two full days after the report to observe the response of the stock price. If the price of FB stock falls significantly after the report, the stockholder will have the choice of either (i) liquidating the stock at $27 per share or (ii) selling the Feb 27 put for a profit that will offset some of the loss in the stock price.

Of course, it is possible that the price of FB stock will be either above $30 or below $26 when the expiration date of the short options arrives on January 25. If the stock price is above $30, the short put will expire worthless and the stock holder can choose to either buy back the short call or allow the stock to be called away for a nice profit. If the stock price is below $26, the short call will expire worthless and the diagonal spread composed of the long Feb 27 put and short Jan 26 put can be sold for a profit.

While this weekly options strategy was presented as a protection for actual shares of FB stock, it applies equally well for an options position that represents synthetic stock. In a Seeking Alpha article of August 15, 2012 (with follow up commentary), I presented an options approach to safely construct a synthetic long stock position in FB. The protection strategy presented here can also be used in conjunction with that synthetic holding.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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. I have no business relationship with any company whose stock is mentioned in this article.