Options Opportunities with Earnings Volatility

      An Educational Piece from Optionshouse

This is Part I of a two part educational series on trading options using WhisperNumber's Whisper Reactor data and services. A Whisper Reactor is a company that is most likely to see a positive price reaction when they beat the whisper number, and see a negative price reaction when they miss the whisper number. The 'whisper reactor' companies, and expected price movement following earnings release, are available to subscribers of the Whisper Reactors service.

The majority of our clients not only 'buy' and 'short' stocks with the Whisper Reactor data, but also trade options as it can offer higher leverage with lower risk. These two reports, provided by Optionshouse, provide detailed information on the essential options trading strategies most likely to be used along with our Whisper Reactors data.


OPTIONS FOR EARNINGS EVENTS

If you follow WhisperNumber.com's approach to earnings expectations, then you might appreciate how investors and traders can use equity options to benefit from an earnings event surprise, and the subsequent stock reaction. Why options for earnings events? Because options offer investors and traders higher leverage with lower risk, and this means a much more efficient use of capital for tactical earnings plays with 'Whisper Reactor' companies. In this report, we'll look at some of the basic option strategies that can profit in various earnings volatility scenarios.

"Options offer
investors and traders
higher leverage
with lower risk"
A quick summary of WhisperNumber is needed: WhisperNumber.com collects 'earnings expectations' (whisper numbers) from individual investors. How do these whisper numbers impact stock prices? Simply put, when a company misses the whisper number the stock is basically 'punished' and should see a decline in price after earnings are released. And, on average, when a company beats the whisper the stock is rewarded and should see price gains after earnings are released.

WhisperNumber.com analyzes its proprietary data and looks for those companies most likely to react (as expected) to beating or missing their whisper number. These companies are called 'Whisper Reactors' and the key data for options trading is the expected price move (of these Reactors) within a specific timeframe following an earnings report. The price expectation is based on whether the company reports earnings that exceed or fall short of the 'whisper number'.

We can use options to express an opinion about the unknown outcome of an earnings "beat" or "miss" in a multitude of ways because options by their very nature offer so much versatility. The obvious plays when an investor's confidence is high for a Whisper Reactor to beat or miss are simply to buy a call or buy a put-and this is also a great approach after the earnings when the unknown becomes known. Let's first look at some possible earnings plays using calls and puts about 30 days in advance of an earnings event.

CALL THE BEAT

Assume that stock XYZ is a Whisper Reactor trading at $65, with earnings coming up in 5 weeks on October 24th, and a whisper number of +11-cents versus a consensus of +9-cents. As a Whisper Reactor stock, XYZ is also classified according to the expected moves that are likely to occur in given time frames, such as within 1-day of earnings, 5-days of earnings, 10-days of earnings and so on. Let's say that XYZ is a "10-day Reactor" with an expected move of +4.2% for a beat and -9.3% for a miss based on the WhisperNumber probabilities.

"Let's look at some possible earnings plays using calls and puts 30 days in advance of an earnings event"
If we want to trade this earnings event for the possible beat, we might buy the November $70 strike call. We need to invest in an option whose expiration is sufficiently subsequent to the earnings date so that our investment has time to realize a potential gain from any possible stock movement. The next available option after the October 24th earnings date is the November contract, which will have approximately 4 weeks of life to react once the company reports.

If we pay $2.50 for the November $70 strike call, there are several ways the trade could unfold, some with a sizable potential profit (on a percentage return basis)-and all with our risk limited to the $2.50 premium we paid for the option. Here are three possible scenarios where positive movement in the stock before or after the earnings announcement could result in a gain or loss on our option trade. All trade examples are hypothetical and exclude transaction costs, commissions, and tax implications.

    Scenario #1: XYZ reports +13-cents on Oct. 24th beating the whisper number by 2-cents. The stock soars in 5 days to $71, and our call is trading for $5.00. If we are able to sell the call for $5.00, we have doubled our money. We might want to take our profits here if we can because the stock has already exceeded the average expected move in only 5 days (+9.2% actual vs. 4.2% expected in 10 days).

    Scenario #2: XYZ reports +11-cents, in-line with the whisper. The stock drifts higher to $67.50 in a few days, but the November $70 call option drops in value to $2. Since we did not get the beat we expected, and the call's value is dropping as the stock drifts and time passes towards expiration, we may decide it is a good idea simply to exit the trade and recover what premium we can. If we sell the call for $2, we realize a 50-cent loss.

    Scenario #3: Since we originally purchased the call 5 weeks before the October earnings, we had that time period to be exposed to any volatility and price movement prior to the event. Suppose that positive momentum and pre-earnings expectations send the XYZ stock to $70 one week before earnings. At the same time, option volatility may have risen as well, causing the premium of the November $70 strike call we own to rise even more, say to $5.50. If we are able to sell our call for $5.50, we could realize a profit of $3.00, a week before the earnings announcement!
PUT THE MISS

"Buying a put is a low risk way to hedge a stock investment, it is also an ideal vehicle for speculating on a Whisper Reactor earnings event"
Since buying a put is a low risk way to hedge a stock investment or to benefit from the potential drop in a stock's share price, it is also an ideal vehicle for speculating on a Whisper Reactor earnings event if one believes that a miss is imminent. Using stock XYZ again with a whisper of +11-cents, if an investor feels that +9-cents is more likely, he or she is obviously looking for an earnings miss and would like to capitalize on the potential 9.3% move lower for this "10-day Reactor." With XYZ at $65 and 5 weeks until earnings on October 24th, an investor might consider buying the November $60 strike put or the Nov $55 put. The $55 put will be cheaper than the $60 put because it is further "out-of-the-money." Let's say that an investor is looking for a big move on XYZ's miss and he is willing to accept a break-even point that may be farther away in order to gain more leverage in the trade with a bigger option position.

Below are three trading scenarios with various position sizes and expirations where lower movement in the stock before or after the earnings miss could result in a gain or loss on a put option trade. Again, all trade examples are hypothetical and exclude transaction costs, commissions, and tax implications.

    Scenario #1: We buy 2 Nov $55 put contracts for $1 each, for a total investment of $200 (excluding commissions). XYZ drifts lower to $61 before the October 24th earnings release and the 55 puts are trading for $1.50. An investor could take profit here on the options with a 50% gain. But, let's look at what could happen if she stays in the trade through the earnings event. If XYZ reports +8-cents (vs. the whisper number of +11-cents), the stock could quickly achieve a drop similar in size to its "10-day Reactor" expectation of -9.3%. Assume the stock drops to $56 within 2 days of reporting. With just over 3 weeks left until expiration, the $55 strike puts might be trading for as much as $2 or $3 depending on volatility. Even though the options have not gone "in-the-money," they have gained significant value because of the possibility that they might before expiration. An investor could take profit on these options, and realize up to a 300% gain per contract.

    Scenario #2: An investor buys 5 December $55 put contracts for $2.25 each, for a total investment of $1,125. XYZ falls to $59 one week in advance of earnings and the puts are trading for $3.75. The investor could close the position on 3 of the contracts and take profits of roughly $1.50, or 67%. Holding 2 contracts through the earnings announcement, if XYZ reports +8-cents, the stock may react further and drop to $53 over the next week. Here the Dec 55 puts might be trading for as much as $4 or $5 with just over 6 weeks until expiration. If the investor were able to sell the remaining 2 contracts of his position for $5, a $2.75 profit per contract would be realized. The total return on this trade might reach $1,000, or a gain of 89% on the $1,125 initial investment.

    Scenario #3: As in scenario #2, an investor buys 5 December $55 put contracts for $2.25 each. Assume that this time, XYZ falls to $61 before earnings and the investor is able to take profit on a part of the position, selling 2 option contracts at $2.75 for a $0.50 profit. But when XYZ reports in-line with the whisper number, the stock stabilizes above $65 and the investor realizes that it is time to exit the rest of the position because there will not be a typical Whisper Reactor move this earnings quarter. The good news is that the December put contracts with over 7 weeks of life remaining will not lose time value as quickly as November options would and the investor might be able to sell the options for anywhere between $1 and $2 each. If the investor is able to sell the remaining three option contracts for $1.50, he or she will realize a loss of $0.75 each on them. The net loss on this investment in 5 December put options might be in the neighborhood of $125 (3 x 75-cents loss - 2 x 50-cents gain = $125 net loss). The $125 loss would translate into an overall return on the $1,125 investment of -11.1%.
POST EARNINGS OPTIONS TRADES

Another way to play the earnings trade is to buy a call after a Whisper Reactor has beaten the whisper number, or buy a put after a Whisper Reactor has missed the whisper number. The good news is that you now have confirmation - the unknown is now known - and you can invest with higher confidence that a Whisper Reactor will make the expected average move higher or lower. The trade-off is that a good chunk of the post-earnings stock move may have already happened in the trading session following the earnings release. This trade-off is much more manageable and tolerable on a risk/reward basis than buying or shorting the underlying stock because options have lower and limited risk relative to their underlying stock.

For a daily look at options activity on stocks-especially before and during company earnings reports - tune into the SideWinder™ Real-Time Update at www.ONN.tv. Veteran options trader and risk manager Jud Pyle scans the equity options markets on the open every day and pinpoints those stocks with significant options trading action, such as high volume and volatility surges or declines. The SideWinder™ is filmed on the trading floor of the Chicago Board Options Exchange and is an exclusive free service of The Options News Network.

When all is said and done, using options to capture the potential volatility of a Whisper Reactor is a highly favorable risk/reward approach. Limited risk (for option buyers) and relatively higher leverage (versus buying or shorting stock alone) make options a solid choice for playing the uncertainty and volatility of an earnings event. As always, be sure to consult your broker or financial advisor before initiating any options trading strategy. Happy earnings season!

Written by Kevin Cook, Optionshouse



Kevin Cook was an institutional foreign exchange market maker for 9 years before signing on with the Optionshouse Options News Network as an options instructor and market analyst. He studied philosophy in college and wanted to teach, but ended up on the floor of a commodity exchange where he learned trading and derivatives from the ground up.


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