Use an at-the-money vertical spread to make a big-ticket earnings play

January 31, 2013 06:00 PM
Options Strategy

Question: How can you make a big-ticket earnings play on a small budget?

Answer: Execute an at-the-money vertical spread.

Suppose Apple or some other big stock is going into earnings. You want to take a directional shot, but you don’t want to commit the large amount of capital that is required either for a stock purchase or as margin for a short sale. One affordable alternative would be to trade options, but then you’d have to worry about additional factors such as volatility and time decay; or would you?

A popular option strategy for earnings plays is the at-the-money vertical spread. It can be constructed using calls (for a bullish play) or puts (for a bearish play), and it consists of buying an in-the-money option and selling an out-of-the-money option of the same expiration, such that both strikes are roughly the same distance away from the stock price. To illustrate, consider the following example using Google (GOOG).

With GOOG trading near $755 on the day before earnings, assuming you had developed a bearish opinion on the stock, you could have placed the following option trade: 

  • Long the 770 puts, about $15 in-the-money, and
  • Short the 740 puts, about $15 out-of-the-money.

Because the option strikes are roughly the same distance away from the stock price, this vertical spread has some very attractive qualities. 

First, it becomes fairly simple to approximate the price. Give or take a small amount to account for factors such as interest rates and skew, at-the-money vertical spreads tend to be worth roughly half of the difference between the strikes. Note that because in this example the 770/740 put spread is $30 wide, the cost of the trade is roughly $15, or $1,500 per spread. As long as the stock remains close to the middle of the two strikes, the spread should see very little change in value.

Second, by placing this trade with the strikes roughly equidistant from the stock price, the option greeks other than delta tend to be very close to zero. In essence, you are now risking $1,500 to potentially make $1,500, without having to dwell much on factors like volatility or time decay. Your only real focus is stock direction, just as it was when you were thinking of trading the stock, except that your overall risk is considerably smaller. 

At-the-money vertical spreads are directional trades, and as such, they are subject to directional risk, otherwise known as delta. In the case of your put spread, you are indicating that you have a bearish opinion on the stock as you approach earnings, so your delta value is negative. However, note that in contrast to a straddle — another popular earnings play — all of the greeks, especially theta and vega, are virtually non-existent. Furthermore, the straddle costs, and therefore risks, almost three times as much as the vertical spread. 

So, what happens once the stock makes its move?

In this example, GOOG dropped $60 upon the next day’s earnings announcement. As such, the trade was able to attain maximum profit. This is shown in the image below:

Note that because of the large move, both puts are now so deep in-the-money that the greeks all are fairly close to zero. At this point, all that is left to do is to close the trade out and take your profit. However, a popular alternative to exiting the trade would be to buy the 740 call trading for about 15¢. This purchase would lock in the same profit less the 15¢ while leaving room for unlimited upside, should the stock make a significant rally the following day. This can lead to significant low-risk profits because reactions to earnings announcements, both positive and negative, often are overdone and there may be some retracement the following day. 

Because the volatility and time decay risks are significantly minimized, you can trade at-the-money vertical spreads using weekly options. In fact, you can trade them even on earnings day, just before the announcement. So long as the stock sits in between the strikes, the position typically does not hurt you much.

That said, this trade still has directional risk, and picking stock direction is not easy, so be sure to consider your risk level wisely. The maximum risk is going to be about half the difference between the strikes, so the wider you go, the more you’ll risk. Note that because we chose the 770 and 740 strikes for our put spread example, we risked about $15 to make $15. 

Alex Mendoza is a former CBOE market maker trained by Susquehanna International Group, and founder of option education firm OptionABC.com. Alex has written extensively on options and has presented option seminars around the globe.

About the Author
Alex Mendoza is the chief options strategist with Random Walk, which has produced numerous articles, books and CDs on options trading, including a book on broken-wing butterfly spreads. Visit their Web site:  www.RandomWalkTrading.com