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January 25, 2012 at 08:15 AM EST
4 Trades to Profit from the Unpredictable Swings of Earnings
Make earnings gains in 4 big names with these surprisingly conservative options plays

Many investors tend to avoid trading through earnings season simply because stocks can make unpredictable moves. However, avoiding these unpredictable moves is a huge missed opportunity.

The problem most investors run into is they simply don’t know how to structure the right kind of trade to take advantage of a modest move. The most common “non-directional” trade is a long straddle or strangle.

The long straddle is often used as a strategy to trade earnings when you believe a stock will move … but they’re not sure which direction. By buying a call and a put at the same strike price, with the same expiration date, you hope to earn more on the winning side of the trade than you lose on the other side.

The long strangle is a similar strategy, but one in which the strike prices are different. You’re still buying a call and a put that have the same expiration dates. But the call you buy would have a higher strike price than the put you buy. This strangle may appeal more than the straddle because it should be just a little cheaper to enter.

A Better Way to Trade Earnings With Options

While it is true that long straddles and strangles can make money no matter which direction the stock moves, neither strategy is a good fit for earnings because they become very expensive to buy prior to the report.

Take a look at what happened with Google (NASDAQ:GOOG). The straddle on GOOG before it reported earnings cost over $35, with only one day until expiration! This is because the implied volatility on the options was around 120%, making them very expensive. (That’s $3,500 a contract!)

Basically, after you’ve spent $35 a share to trade the straddle, you need for the stock to make a move that’s bigger than what you’ve spent to recoup your capital on that trade. Rather than betting GOOG will make a $35+ move over earnings in order to show a profit, it is better to bet on a much-smaller move to make your gains.

Wouldn’t You Rather Get Paid to Trade Earnings?

A simple twist on a common income strategy makes for a great “hold over earnings” trade. The long butterfly — where you sell two at-the-money options and buy one out-of-the-money on each side — is a trade many investors use to benefit from time decay.

The time decay is compounded by the weekly options’ always-fast-approaching expiration date. (So, you won’t be seeing $35-a-share prices like Google’s on the day before expiration!)

We’ve talked about long strategies so far with the straddle, strangle and butterfly. There are also short strategies, that give you income. Now, you’d take on an incredible amount of risk doing a short straddle or strangle. But a short butterfly – buying two at-the-money options and one two out-of-the-money option on each side – is actually a fairly conservative strategy … and one that can work for you.

By taking the short side of the butterfly, we can benefit from a much-smaller move in the stock, without having to put excessively large amounts of capital on the table. I am doing the following trade now on Caterpillar (NYSE:CAT) going into and most likely holding over earnings.

Trade #1 — Caterpillar

With the last two earnings reports on CAT the stock moved $4 and $7, putting the odds in our favor that this trade will make money over earnings, if not sooner.

With CAT trading at about $105 I am structuring the following position:

  • Selling 10 $100-strike calls for Jan 27th expiration
  • Buying 20 $105-strike calls for Jan 27th expiration
  • Selling 10 $110-strike calls for Jan 27th expiration

This position can be done for a $1.60 credit. Therefore, it doesn’t matter exactly what you pay or collect for each option, as long as you end up with a net credit of $1.60 ($160 a contract) in your pocket.

This trade makes money from a $3.50 move in either direction over earnings (or even prior to earnings).

Three other stocks are presenting the same opportunity that you can advantage of. Let’s take a look at the next one, on Page 2.


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