Option spreads are a great way to take a position based on your expectations for how a stock will perform after the release of earnings. The beauty of this strategy is that you can know with certainty what you stand to make and lose before you enter the trade.
Speculating on what’s going to happen to a stock price after an earnings announcement is clearly just that – speculation. Obviously, we can’t know for sure. But if we combine the Zacks Rank and an understanding of the pattern of earnings beats (or misses) for a company in the recent past, we can make an educated guess about what’s likely to happen and devise a sound options trade to profit if our hypothesis is correct.
Volatility in the price of a stock tends to increase right after the announcement of quarterly earnings. While this presents an opportunity for a successful trade, it also means that losses will be magnified in the event that we are incorrect. Simply taking a long or short position in the stock can be painful when we’re on the wrong side of an earnings beat or miss, but smart options trading can let us mitigate the damage when we’re wrong – and profit when we’re right!
When a Butterfly Flaps its Wings
The options spread that’s perfect for taking a position on what will happen to a stock price after announcing earnings is the butterfly. Professional options traders often design their positions around this concept.
The idea is really fairly simple. For simplicity, we’ll talk about a call butterfly (bullish expectation), but the exact same strategy could be applied to puts (bearish expectation) as well.
To trade a butterfly, a trader buys one call option, sells two call options at a higher strike price and buys one more call at an equidistant higher strike.
The maximum loss on the position is the total premium paid for the options. No matter what happens to the price of the stock, the worst-case scenario is that the spread expires worthless.
The maximum profit from the trade is the difference between the strike prices, minus the premium paid to enter the position.
We will generally use the shortest dated options available. These usually offer the most “bang for your buck” in that you’re paying for the least amount of time premium.
A Real-World Example:
Netflix (NFLX - Free Report) reports Q1 earnings on Monday April 16th. With a Zacks Rank #2 (Buy), NFLX tend more often than not to surprise to the upside. During the last 6 quarters, the average price movement in the 2 days immediately preceding and following an earnings announcement is +$12.60. If your hypothesis is that earnings are likely to come in slightly higher than expected and that the stock price will rally 2-4%, you could construct this butterfly trade:
(We will use the options that expire Friday April 20th. The current stock price is approximately $297. For the purposes of this example, we will ignore commissions and fees.)
Buy one 300 call (Current ask $15.25)
Sell two 310 calls (Current bid $10.70)
Buy one 320 call (Current ask 7.45)
For this spread, we have paid a total of $1.30.* This is the maximum amount we can lose. If the stock price is less than 300 or greater than 320 when our options expire, the spread will be worth zero and we will have forfeit the entire amount we paid.
If, however the stock behaves as we expect and rallies $13 to $310, our spread will be worth $10. (The 300 call we own will be worth $10, and all other options will be worthless.)
Subtract the $1.30 we paid for the position and we have a whopping profit of $8.70!
Standard options contracts represent 100 shares of the stock, so this equals $870 per spread.
Even if we’re not exactly correct about the price movement, as long as the stock ends up between $301.30 and $318.70, we at least breakeven on the trade. Everything in between those prices provides us with some profit, with the maximum coming if the stock settles right at the strike we’re short.
This strategy is best suited to stocks that have a history of moving significantly after announcing quarterly results.
All the FANG stocks report in the next 3 weeks. Facebook (FB - Free Report) on April 25th, Amazon (AMZN - Free Report) and Alphabet on April 26th. You can use the analysis tools on Zacks.com to make your own estimate about where the stocks are likely to end up after the announcements and buy a butterfly to profit if the stock proves you right, while limiting your exposure if you get surprised.
*A note on execution – This example uses the current bids and offers available in the marketplace. The net is the worst price available at which we could execute the trade. In reality, if using a broker with spread-trading order entry capabilities, it’s likely that we could buy the butterfly for considerably less, for instance $1.10 or $1.20 if we bid on it as a spread rather than “legging” the individual options.