OptionSage submits:
As we say sayonara not only to the dollar but also to September’s expiration month, it is tempting to view the dawn of a new expiration month as an opportunity to take advantage of hefty premiums for October. Some subscription services will even offer you the ability to scan option chains in order to identify options with most premium! While this might seem to be highly advantageous, landmines exist that must be avoided!
When option premiums are high, they are high for a reason. The implied volatility on the option expands, thereby pricing in a bigger move in the underlying stock. If you were to sell call or put options in expectation that they would expire worthless, you may be in for a BIG surprise as the stock ends up moving too far, too fast, causing the short options to move in-the-money, thereby resulting in assignment.
As option traders, we need to recognize that when we see option premiums that appear much higher than they were a month or two ago, a reason exists why they are high and we need to know what that reason is. Four times a year, the reason is earnings and this means we need to modify our trading styles in anticipation of earnings.
Before noting a checklist you can use for earnings, I’ve noted below a list of companies reporting during the month of October. If you spot a company you are trading on the list, don’t ignore it!
Anything can happen at earnings! A company can beat expectations but announce poor forward looking guidance, causing the stock to be punished. Alternatively, a company could announce dismal earnings but project a fantastic upcoming year, which may result in big stock price gains. In short, even if you do enormous due diligence on the fundamentals of the company and you are correct, the stock price may not move in the expected direction as analysts grab hold of a key metric or piece of data as an excuse to move the stock one way or the other. (If you don’t see your company on the list below, just check the free service offered by www.earnings.com)
(While most companies announce earnings during “earnings season” – the months of January, April, July and October – others such as Goldman Sachs, Lehman Brothers, Bear Stearns, Morgan Stanley, Sears Holdings and many others will report outside the standard cycle)
October Earnings
October 1: Walgreen
October 2: Pepsi Bottling Group, Micron Technology
October 3: Arrow International
October 4: Marriott International, Family Dollar, Constellation Brands
October 5: ATS Medical
October 8: Yum Brands,
October 9: Alcoa, California Pizza Kitchen
October 10: Monsanto Company
October 11: PepsiCo, Safeway, Costco
October 15: Rockwell Collins, W.W. Grainger
October 16: Intel Corporation, KeyCorp
October 17: Ebay, Stryker
October 18: Southwest Airlines, The Hershey Company, Google, Xilinx
October 19: Honeywell, Schlumberger, Xerox, Citigroup, 3M Company, Caterpillar
October 22: Schering-Plough, Halliburton, Hasbro, Texas Instruments, Merck
October 23: Tellabs, Nabors Industries, AT&T, DuPont
October 24 Symantec, General Dynamics, Moody’s Corporation
October 25: EMC Corporation, Amgen, Raytheon, MBIA, Cummins
October 26: Baker Hughes, Coventry Health, Waste Management, Ingersoll-Rand
October 29: Humana, Pitney Bowes, Radio Shack Corporation
October 30: Procter & Gamble, Office Depot, Liz Claiborne, Colgate-Palmolive
October 31: Transocean, Weyerhaeuser, Wyndham Worldwide
If you are trading any of the companies above, think of each of these dates as a big sign that flashes WARNING! Almost anything can happen to your company subsequent to its earnings report announcement so an earnings checklist is warranted. (Note the rules below are some that I tend to adhere to but obviously you should consider rules that meet your risk tolerance)
Item 1: Avoid Credit Spreads – such as bull puts and bear calls on companies that report earnings prior to expiration.
This rule does not have to be adhered to 100% of the time because sometimes you can enter trades with approximately a month to go to expiration and then exit the trade with just a few days to go to expiration – assuming the company is reporting earnings just a day or so before expiration. However, it is a good rule of thumb in general to adhere to this rule because the risk assumed in credit spreads relative to the potential reward is high and volatility following earnings can damage these spreads in short order.
Item 2: Hedge More
The last thing I want is to have a bunch of un-hedged long calls on a bullish stock going into earnings. If I have made some nice gains on long calls ahead of earnings, I tend to either take some profits off the table or hedge with short calls or long puts depending on my expectations.
This rule applies equally to long puts. For me I would not want to go into an earnings announcement without hedging with long calls – just in case my bearish expectation was not met.
For those of you following Phil recently, you saw how this strategy offset pain on the long put side as the Fed announced its huge cut. This is CRITICAL to survival and this type of hedging is exactly why Phil is such an outstanding trader.
Item 3: Avoid new Call Calendar Trades.
Since earnings means volatility, new calendar trades are not the optimal earnings play! Calendar trades take advantage of time-decay on the short options and are not designed to profit when explosive movement up or down occurs. This doesn’t mean if you have some LEAPS options and are regularly shorting options against the LEAPS that you cannot continue to do so. What it does mean is don’t start out a new trade with a 3-month long call option and hedge it with a 1-month short call option unless you are prepared to commit to that trade for another few months to get it back to profitability or breakeven in the event the stock gaps up or down at earnings.
A preferred approach is to have maybe 3 long options for every 2 short options. This is exactly what Phil did last earnings on Baidu and when the stock soared – the additional long call he had in place resulted in BIG PROFITS!
So, as we approach another earnings season, look to trade smart and, by following the rules, you should rarely run into too much trouble and can still target handsome profits!
Trade Safely!
OptionSage
