Q & A. Buying Puts and Calls Prior to Earnings Announcement

I followed you from your posts on TMF [The Motley Fool] and now read the blog religiously. You are providing a fantastic service for those of us wanting
to learn more about options.
[Thank You!]

This sure bought home to me the volatility of options and was pure luck on the timing, I claim no "credit" for it other than the original pick
– yesterday I thought "Hmm, CHK might do well it Obama wins and downside is limited, as it is already hammered". I bought 10 Nov 30 calls for pennies.

Today they were up 1300% at one point on some (more than likely bs) rumor that BP might acquire them. Sold half for 650%+ of the original investment and holding the other half just in case there is something to the rumors … amazing.

I was just about to buy AMZN puts, then got called into a conference call – sure missed the boat on that one; it would have been a nice 80% gain today.
 
 

Wins like this of course, are nice, but they're not part of a strategy and there was no discipline involved. That is where I need to get to.

Not every trade must be disciplined, if the losses are limited.  But, you want to avoid making too many undisciplined trades. Your overall strategy must be disciplined, and that means trading within your personal comfort zone.

Something else I did recently I'd like to get your opinion on – when SNDK was at 15 and just about to report earnings I knew (believed) it was going to be either up big or down big, so bought 21 calls and sold [bought?] 10 puts. The 21 calls are down close to 99%, but I sold the puts at 600% profit. Is it common to be able to play both sides like that when you expect a big move in a stock, with the worst case being "nothing happens"? If "nothing happens" closing the
trade the next day leaves you out some commission, a day time value and perhaps some volatility premium.

I constantly see options moving more than 100% in a day recently, so playing both sides knowing one side of the trade will go to zero seems too good to be true. With these wild swings that "other side" can even come back a few days later. Too good to be true doesn't usually exist in the market, so what am I missing?

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What you are missing is the entry fee to play the game by adopting this strategy.

Yes, it is possible to play both sides.  But, prior to earnings, many people want to own puts and/or calls, and the price of the options increases significantly. That is seen by a jump in implied volatility (IV).  Once the news is released, IV gets crushed.  Thus, when 'nothing happens' you have a loss that is MUCH larger than you might have anticipated.  If you get a moderate move, you may still not make any money because the winning option often doesn't increase in price by enough to cover the loss on the other side.  And this is especially true when you buy OTM (out of the money) options. 

Obviously, when your option moves to 7x the price you paid (congratulations!), you are going to be a winner. 

Bottom line:  Yes, you can do this, but there is not much room for a middle ground – you NEED that big move.  That's why this it’s a difficult strategy.  You must pick and choose your plays carefully.

Do yourself a favor and try to see this for yourself.  Take a look at potential buys for stocks that are about to announce earnings.  looking only at those for which 'nothing happens,' take a look at the price decrease in the options.  By doing this, you will have a much better idea of the risks involved.  I wrote an article (link no longer active)on this some time ago, when market conditions were different.

Two more crucial items: 

1) When you say 'recently' do you recognize just how different the market has been lately?  We have seen unprecedented volatility.  That's one reason you are seeing so many options moving by such huge amounts on a daily basis.  This cannot last forever. 

2) Out of the money options are affected more than other options by the IV level.  Thus, if IV decreases, OTM options can lose most of their value in a heartbeat.

But, if you want to participate in the moves of the ongoing volatile market, then please understand that you are paying a big price for those strangles (calls and puts with different strikes) you are buying. I am not trying to tell you that you are paying too much or that your play is 'wrong.'  But it's important for you to understand that option prices are high (for a good reason).

If 'nothing happens' you lose your commissions and one day's theta – as you mentioned.  But you can lose a ton of money due to a volatility decrease.  Be aware of that possibility.  If taking this risk for the potential reward fits snugly within your comfort zone, then go for it. 

Mark

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