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Options Theory: How to Game the Earnings Gap

February 25, 2018

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Pro Members have exclusive access to 31 powerful trading strategies categorized according to the Options Greeks. Bullish, bearish or neutral market conditions, this Playbook will help you trade with greater confidence.

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When we last departed I left you with an important question. Namely, “what do you do with the knowledge of how much a stock is expected to gap on earnings?” If you’ve yet to read last week’s message, then do so before continuing. Consider the alley-oop to today’s slam dunk.

There are myriad answers, but today we’ll focus on one: bet on it.

Since guessing the direction of the earnings gap is a fool’s errand, professionals bet instead on the magnitude of the move. There is an entire subset of options strategies known as volatility trades designed to take advantage of this very situation. Fundamentally, there are two opinions you can express. Either you think the expected gap is too small, or you think it’s too big. Said another way, you either believe the stock will gap more than the Market Move Move (MMM), or you think it will gapless. In the former case, you’re betting that options are underpriced and in the latter case you’re betting they’re overpriced.

If you’re wondering which is the better bet, here are two things worth remembering.

First, options tend to be overpriced more times than not. That means those betting the stock will gap less than expected win out roughly two-thirds of the time over the long run. This is why professionals favor short option strategies into earnings.

Second, though option sellers hold the upper hand, the payout for their strategies is asymmetric. The rewards are limited and often much smaller than the potential risks. Think of an iron condor or short strangle, for example. One large loser can easily dwarf multiple winners.

The way to make a pure volatility bet into earnings (as opposed to a directional one) involves using delta neutral strategies like the iron condor, iron butterfly, short straddle, or short strangle. Instead of profiting if the stock moves in the right direction, you profit if the stock runs more or less than expected.

Bank on Fireworks

Suppose Apple Inc. earnings report is tonight and the Market Maker Move (MMM) shows an $8 expected gap. With the stock trading at $170, that translates into a 4.7% move. Let’s say based on your analysis (maybe you looked at previous earnings gaps or ATR or the recent behavior of other tech earnings) you think AAPL has a good chance of moving more than 4.7%. That is, you believe option premiums are too cheap.

To capitalize you might buy a straddle.  The trade consists of purchasing the one-month $170 call and $170 put for a net debit of $11. That means you will profit at expiration as long as AAPL rises above $181 or falls below $159. Of course, those are your expiration breakevens. The breakevens now may be as close as $178 or $162.

If true to your forecast, AAPL gapped more than expected (say, $12), then your long straddle would be a winner. Maybe it rises in value from $11 to $13, $14, or more.

Long straddles, strangles, inverted butterflies, and debit condors are the tools of the trader betting on fireworks.

Embrace the Odds

While Apple Inc. may occasionally gap more than priced-in, most of the time, it doesn’t. And that’s why if you want to play the odds you’ll bet AAPL will move less than 4.7%. In this situation, you think option premiums are too rich.

To capitalize you might sell a strangle. The trade consists of selling an out-of-the-money call and an out-of-the-money put. With AAPL trading at $170 let’s say you sell the one-month $190 call and $150 put for a net credit of $2.00. Because of the premium received your expiration breakevens are $148 and $192.

As long as the stock gaps equal to or less than expected this trade should come out a winner.

Short straddles, strangles, butterflies, and iron condors are the tools of the trader embracing the odds.

Earnings trades are definitely a specialty that requires practice and refinement. If you find them to your liking then great. Otherwise, you can always try one of the many other strategies beckoning elsewhere in the options mart.

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