Disclaimer: This post is intended for education purposes only and should not be interpreted as a recommendation. Trading options may not be suitable for all investors.
Options are all about movement and time. The more movement, the more expensive the options. The more time, the greater the likelihood of a move.
As a result, options tend to lose value steadily because each passing day reduces the chance of a big swing in price.
But there is a big exception that rule: The uneven change in an option’s premium around a pivotal event like corporate earnings.
After all, quarterly numbers provide detailed facts on a company’s success. Good news can draw crowds of buyers while a disappointment can unleash waves of sellers. The options market responds by charging more for calls and puts expiring shortly after results are due.
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So if the uncertainty of earnings lifts volatility premiums, it shouldn’t be a huge surprise that extra price evaporates as soon as the report crosses the wires. Many traders look to capitalize on this drop in value by selling options before the news — especially during a busy earnings season like right now.
There are a couple of ways to structure such a transaction. One technique is to sell puts slightly out of the money (below the stock price.) If it holds or rallies, the puts will lose a ton of money in the blink of an eye and the seller makes money.
As an example, let’s consider Apple (AAPL). The tech giant reports earnings after the bell on Tuesday, July 31, so we’ll view the options expiring Friday, August 3.
The risk is the to downside because you’ll be on the hook to buy shares at the strike. But in that case you’ll still make something from the volatility getting crushed out of the options. Notice in the option chain below AAPL’s 3-August 190 puts are bid for $3.20. So even if you’re assigned equity your effective entry would be $186.80 rather than $190. Still, never forget you can lose money all the way down to zero writing puts on anything.
Another strategy is the covered call: You must own at least 100 shares of AAPL and sell calls near the money. In this case you capture a volatility premium from the market is anticipating a potential for a rally. If it surges past the strike you’ll be forced to deliver the shares to someone else. On the other hand, the calls will go worthless quickly if the stock crashes. (You might also lose money on the underlying equity in that case.)
Either way, both trades have certain things in common:
- You get paid upfront, with limited potential for a profit.
- You’ll only make so much from the stock rallying — even if it shoots up 1,000 percent. Realize some people might find that frustrating.
- Both short puts and covered calls have similar downside risk. In either case, if the stock crashes you’ll end up owning them and watching them go lower.
- On the margin covered calls can be viewed as more bearish because they reduce your delta, while selling puts increases your delta.
- Also notice on the options chain below the contracts expiring on August 3 (yellow ovals) have much higher Implied volatility and Extrinsic value than the July 27 options (green). That shows how a potential move after earnings are priced into the August 3 options.
Stay tuned for our next post on diagonal spreads — a slightly more complex strategy involving two different options with two different expiration dates!