In this article, I will describe some of my favorite ways to trade earnings for companies reporting during the week of May 21-25, 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: Guess (NYSE:GES)
Guess reports earnings on Tuesday, May 22, 2012, after the market close. With the stock currently around $25.30, I'm looking at the following trade:
- Buy GES June 2012 25.0 put
- Buy GES June 2012 25.0 call
Trade #2: Dell (DELL)
Dell reports earnings on Tuesday, May 22, 2012, after the market close. With the stock currently around $15.27, I'm looking at the following trade:
- Buy DELL June 2012 15.0 put
- Buy DELL June 2012 15.0 call
Trade #3: Best Buy (NYSE:BBY)
BestBuy reports earnings on Tuesday, May 22, 2012, after the market close. With the stock currently around $18.70, I'm looking at the following trade:
- Buy BBY June 2012 19.0 put
- Buy BBY June 2012 19.0 call
Trade #4: NetApp (NASDAQ:NTAP)
NetApp reports earnings on Wednesday, May 23, 2012, after the market close. With the stock currently around $34.85, I'm looking at the following trade:
- Buy NTAP May Week4 2012 35.0 put
- Buy NTAP May Week4 2012 35.0 call
Trade #5: HP (NYSE:HPQ)
HP reports earnings on Wednesday, May 23, 2012, after the market close. With the stock currently around $22.10, I'm looking at the following trade:
- Buy HPQ May Week4 2012 22.0 put
- Buy HPQ May Week4 2012 22.0 call
Trade #6: Tiffany (NYSE:TIF)
Tiffany reports earnings on Thursday, May 24, 2012, before the market open. With the stock currently around $61.50, I'm looking at the following trade:
- Buy TIF June 2012 60.0 put
- Buy TIF June 2012 62.5 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.
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 positions in the next 72 hours