From the February 2013 issue of Futures Magazine • Subscribe!

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

Options Strategy

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 Alex has written extensively on options and has presented option seminars around the globe.

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