How to Pick Your Options Trades
Less Like Slots, More Like Poker
With the fourth-quarter earnings season in full swing, you may be wondering how you can take advantage of the big jumps or big drops created by earnings announcements. One of the best ways to take advantage of increased volatility is by using options. There are a number of ways to use options, not just buying puts and calls.
I should first say that I am not a big fan of randomly buying a put or a call on a company ahead of its earnings report. Volatility increases on options just ahead of the earnings report and the premiums will increase as a result. This increase in premiums makes it tougher to make a big gain--not impossible, just more difficult. Buying puts and calls in a random manner ahead of earnings reports is akin to gambling. Most notably like playing penny slots- betting a little and trying to strike it rich.
I don't make very many trades ahead of earnings reports. Notice I said I don't make many trades and didn't say I never make trades ahead of earnings. To make a trade ahead of earnings, you have to do your homework.
I recommend doing at least three things:
1. Check the sentiment toward the stock
2. Check the recent performance of the stock before and after earnings
3. Measure the risk/reward relationship
Sentiment toward a stock is very critical heading into an earnings report. Look at the short interest ratio (the number of shares sold short divided by the average daily volume). If the short interest ratio is high (above 5.0), the company could be a good bullish play. The reason for this is if the company beats earnings estimates and jumps higher, the short sellers can add fuel to the fire as they scramble to cover their short position.
Analyst ratings are also a good sentiment indicator. If a company has 20 analysts following it and 18 rate the stock as a "strong buy," the odds of the company getting an upgrade after the earnings report are very small. On the contrary, if there are 20 analysts covering the stock and 15 rate the stock as a "hold" or lower, the company could see a number of upgrades if the earnings are well above expectations.
Looking at a chart of the stock before and after the earnings release can alert you to any patterns that may exist. For example, Peabody Energy (BTU) appeared on my bearish scan recently and I looked at making a recommendation in the Cabot Options Trader. However, when I looked at the earnings calendar and saw that BTU was releasing its earnings on January 24, I looked at the following chart:
The grey squares represent when the company released earnings in the last nine months. The first thing that jumped out at me was how the stock had trended higher heading into earnings and then fell following the earnings release. Here's the funny thing: In the earnings report in July, the company beat expectations. The October report fell short of expectations yet the stock jumped more than it did in July. Needless to say, I did not make a bearish recommendation ahead of the earnings report, but you can bet I will be watching the stock closely following the report.
The third thing I recommend doing before making an option trade ahead of earnings is measuring your risk/reward ratio. How do you do this? First, by looking at the sentiment indicators and the previous earnings announcements, you can get a good idea of which way you want to play it--long or short. Once you have determined the direction you want to play, you will want to look at the different options available--which month and which strike price.
One recent example that I looked at was Cree (CREE). The company was set to release earnings on January 17 after the market closed and January options were set to expire on Friday, January 20. The short interest ratio came in at 5.1 indicating a bearish sentiment. I looked at the January options thinking they might be relatively cheap with the short life they had, but as I mentioned earlier option premiums tend to jump ahead of earnings announcements.
The stock was trading around $23.50 when I looked at the options, so I looked at the January 23 and January 24 strike calls. The asking price on the January 23 strike calls was around $1.80 at the time and the January 24 strike calls were at $1.20.
I looked at three different scenarios for what might happen on the upside: the stock jumping 5%, 7.5% and 10%. A 5% jump in the stock would have meant it was trading in the $24.67 range and the 23 strike calls would have been worth about the same amount as the price heading into the earnings announcement. The 24 strike calls would have been selling for around $0.70, which would mean a loss of over 40%.
If the stock were to jump 7.5%, this would mean a stock price of around $25.25 and the 23 strike calls would be selling for $2.25 and a gain of 25%. The 24 strike calls would be selling for around $1.30 and a very small gain.
Looking at the 10% scenario, the stock would be trading in the $25.85 range. The 23 strike calls would jump to $2.85 for a gain of 58% and the 24 strike calls would jump to $1.85 and gain just over 50%.
Keep in mind that if the stock dropped after earnings, it would only take a drop of 3% for the 23 strike calls to be out of the money and expire worthless and the 24 strike calls were starting out of the money. In either case, if the stock dropped more than 3%, we would be looking at a loss of 100%.
This is another instance where I decided not to make the trade. Knowing that a small decline in the stock could create a 100% loss and that the best-case scenario with a 10% jump in the stock would create a gain of 58%, I did not like the risk/reward ratio.
If you take the three steps that I have outlined here, making an options trade ahead of an earnings report might feel a little less like playing the slots and a little more like playing poker. While poker is another form of gambling, at least you get to make your decision on whether to stay or fold based on probabilities and not just luck.
Good luck and good investing,
Editor of Cabot Options Trader
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