By Dr. W. Edward Olmstead
Shareholders are naturally concerned as the date of an earnings report for their favorite stock draws near. Stocks often experience their biggest declines in price after an earnings report fails to meet the expectations of investors. The recent price action in Apple Inc (AAPL) is a perfect illustration. This widely held stock lost more than 12% of its value following its most recent report.
Now that many stocks have weekly options, there are new strategies available for earnings report protection. Weekly options can provide low-cost, short-term insurance to lock in a minimum sale price of a stock that is potentially vulnerable to an earnings setback.
It has always been possible to use monthly put options to protect the price of a stock through the date of the company’s earnings report. The problem with monthly puts is that they can be quite expensive, particularly when the options expiration date is substantially later than the earnings report. Weekly options are cheaper and offer more flexibility in providing short-term protection.
Not all stocks have weekly options, but when they are available, it is prudent to know how to employ them to circumvent an earnings report disaster. There is a cheap but effective strategy to protect the stock price through its earnings report by using a combination of weekly options. It is easiest to present this protective strategy as a combination of two separate trades.
The first trade is the purchase of a weekly put option that expires on the closest Friday following the earnings report. For every 100 shares of stock, buy one contract with a strike price that is slightly below the current stock price. While this short-term, protective put provides for a minimum sale price of the stock, it may still seem relatively expensive because option prices often inflate ahead of an earnings report. A second trade is implemented to lower the cost basis of the protective put.
The second trade uses weekly options that expire one week prior to the expiration date of the protective put. For every 100 shares of stock, sell one call contract with a strike price above the current stock price. Also sell an equal number of put contracts with a strike price that is one strike below that of the protective put. The premium received from the sale of these options will substantially lower the cost basis of the protective put.
It is typically best to do these two trades about two weeks prior to the earnings report date. It is important to understand what has been achieved with these trades. The long stock together with the short call represents a covered call position. The long protective put together the short put represents a diagonal time spread. There is no margin requirement associated with either of these positions.
Since the stock price tends to remain in a relatively narrow range prior to the earnings date, it is expected that both of the short options will expire worthless on the Friday prior to the earnings report date. This leaves the protective put in place for full effect through the following week.
If the stock price falls significantly after the earnings report, there are two alternatives available to the shareholder. For those who are no longer interested in owning the stock, it can be liquidated at the strike price associated with the protective put. Some shareholders may want to maintain their stock position even after a pull back in price, in which case the protective put can be sold for a profit to offset most of the lost value in the stock. If the stock price soars after the report, the protective put will expire worthless, but there is no cap on the profit that can be achieved by the stock.
Some comments are in order regarding the unexpected cases in which the stock price will have moved sufficiently (up or down) during the week before the earnings report that one of the short options will be in-the-money as its expiration date arrives. If the stock price is above the strike price of the short call, the shareholder can either buy back the short call and wait for the earning report or allow the stock to be called away for a profit. If the stock price is below the strike price of the short put, the short call will expire worthless and the diagonal put spread can be sold for a profit. In this latter case, the stock will no longer be protected through the earnings report.
Dr. Olmstead can be found at http://www.olmsteadoptions.com, an on-line options trading site, centered around options education material and option trading strategies he’s developed. He is Professor of Applied Mathematics at Northwestern University, author of the popular and highly-praised options book, Options for the Beginner and Beyond (2006) and former chief strategist for The Options Professor on-line newsletter, distributed by Zacks.com and Forbes.com.