Trading Options during Earnings Season

In this post I will look at one basic, yet a very effective, strategy on trading options during earnings season.

Options are not for the weak hearted! You only deserve the gains if you can take the losses. By no means am I an options prodigy. But sometimes, the simplest of strategies can result in ridiculously phenomenal gains.

I'll take you back to summer 2008 earnings season when financials were battered.

It was Monday, July 14, 2008, before the opening bell. Options were expiring on the coming Friday. A major downtrend was in play and call option premiums were cheaper than candy. Analyst expectations from financials were extremely pessimistic. Major financial institutions including WFC, MER, GS, JPM, MS, and BAC were lined up to release earnings. WFC was set to release earnings first.

Much to everyone’s delight, WFC releases better than expected earnings. There was a ray of hope. A belief of survival that things are not as bad as it seems. The result, WFC moved higher and its peers followed.

Options traders had plenty of time to make their move. All they had to do was understand a simple concept:

Often, a particular firm-specific event propels the company’s price and moves the whole industry/sector with it.

WFC’s better than expected earnings release was that event which propelled the financial sector higher. I remember the Ask price on 1 OTM GS Call was about $.30. The premium on this call did not budge higher for 1-2 hours after WFC’s earnings release. In the next 2-3 days, the $.30-$.50 was more than $11. So, if you had invested $150 (ignoring commission), then the $150 would be $3,300-$5,500. There was one case where the return would be $11,000 with an investment of about $1,000.

Although these results are not as spectacular as GOOG, they are spectacular nonetheless. Anyone can achieve these results if they don’t sell prematurely.

The process is quite simple but should require proper due diligence.

1) Identify the sectors and the industry you want to trade. Ideally you would want to find overbought or oversold sectors because volatility is greater in overextended markets.

2) Determine when options expire.

a. I prefer trading those industries who report earnings towards the end of the month
because option premiums are much lower.
b. Sometimes if there is a big run-up before earnings release. In this case, option
premiums are much expensive and are possibly already overbought.
c. When there is a big run-up before earnings release, the earnings surprise and
guidance has the surpass analyst expectations by a larger margin for the after-move
to be significant.
d. More often than not, you will observe light trading volume before a company releases
earnings.

3) Identify the order in which major companies of the selected industries that are set to release earnings.

4) If the first company that releases earnings surpasses analyst expectations and offers favorable guidance, then buy moderately out of the money calls on the company’s industry peers. If the company’s prospects are gloomy, then buy puts on it’s industry peers.

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Sanjeet Parab_____________________________