The easiest way to make a directional bet around an earnings release is to buy a call option to be bullish or buy a put option to be bearish.
The trouble with that approach is there are more factors that go into the performance of those trades than the directional move in the stock.
We are going to walk through an example using Tesla (Symbol: TSLA) to show how we approach an earnings-related trade.
Options Pricing Model
Before we get into the specifics on TSLA, let’s review the options pricing model to highlight the factors that will impact the performance of an options trade.
There are 6 different inputs in the pricing model of an option:
-Time to expiration
The two inputs that we need to be most concerned with for an earnings trade are the Stock Price and Volatility as the potential for big moves due to these 2 factors is extreme.
Let’s take a look at TSLA using a few potential earnings trades to highlight the pros and cons of using a long option and a short option approach.
Pros And Cons Of Long/Short Options Approach
TSLA has had one the most impressive rallies you will ever see over the last few months. The stock price has gone from $350 back in March to up over $1600 currently. As a result, the stock is massively overbought.
However, there is incredible bullish sentiment in the stock.
We will talk about taking a pure directional trade first.
If you want to put on a directional trade on TSLA expecting a big reaction higher or lower due to the earnings release you could buy a long call or long put option.
The problem with buying long options going into earnings on any stock, let alone an expensive name like TSLA, is the expected big move due to the earnings numbers.
Trade Option #1:
- Buy the July 24 1700 call option
- Bullish Trade
- Cost: $84.10 or $8410 per contract
- Max Risk: $8410
- Max Profit: Unlimited
Trade Option #2:
- Buy the Jul 24 1560 put option
- Bearish Trade
- Cost: $87.05 or $8605 per contract
- Max Risk: $8605
- Max Profit: Unlimited
Market makers are pricing in that uncertainty which is making the options incredibly expensive.
With the earnings out 24 hours from the time of this article, looking at the options trade page we can see the market makers are pricing in a $200 move higher or lower after the earnings come out this week.
The expected move won’t tell you which direction the stock will move in, but it will tell you the expected range higher or lower. With this expected move priced into the options you need a big move to happen to justify the expensive price of the options and make money from the trade.
Not only do we need a big directional move to take place in the stock price, we need it to be big enough to offset the volatility dropping after the earnings uncertainty is out of the way.
Market makers will juice the implied volatility being used to price the options higher to price in the unknown reaction in the stock price. As a result, the options will be very expensive going into the event.
Once the earnings are known, they will suck the volatility back out of the options which will cause them to lose money.
Not only do you need the stock to move higher or lower in a big way with a long call or put strategy around earnings, it needs to be big enough to offset the volatility moving lower after the event.
- The good news is the potential is there for a big return around earnings if you get the big directional move in the stock price in your favour.
- The bad news is in order to make money with these strategies you need a lot to go right in your favour.
Is there anything else we can do to participate in TSLA earnings with better odds of success?
We just discussed how the market makers are pricing in a big directional move into the TSLA options. They are pricing in a $200 move while also spiking the volatility levels higher as well. Knowing this, what can we do to take advantage of these features?
The third trade that we will take a look at is selling a credit spread.
For this example, we are going to take a look at selling a call spread on TSLA. The stock is massively overbought, and we don’t mind leaning bearish on this position. Selling a call spread allows us to put a bearish trade that will tie up far less capital and give us multiple ways of making money on trade.
Trade Option #3:
- Sell the July 24 1710/1720 call spread. We are selling the 1710 call and buying the 1720 call at the same time.
- Neutral to bearish trade
- Trade Price: $3.12 or $312 per spread
- Max Profit: $312 per spread
- Max Risk: $688 per spread
By selling the call spread, we are able to lower the cost of the trade from over $8000 to buy the long option down to $688 for the spread. Not only are we able to lower the cost of the trade, but we will have multiple ways of making money on trade.
We make money on this spread as long as the TSLA stock price stays below $1713.12. If the stock moves higher, lower, or sideways that is fine as long as it stays below $1713.12.
We can also make money from volatility decreasing which is something we know will happen after earnings. Finally, we also can make money from the time decay adding up.
Instead of having one way of making money when buying the long call or put, we will have 5 ways of making money with the credit spread. The trade off is we will also have far less profit potential.
The most money we can make on the trade is the $312 that we are selling the spread for.
If we are dead wrong on the directional move in TSLA stock and the move is higher instead of lower the most we can lose on the trade is $688 per spread. This is far less than the $8000 max loss that could happen if you are on the wrong side of the move with a long call or long put.
Which Options Trade Is Best?
In most cases, when trading around earnings I prefer to sell the credit spreads. While they won’t produce the big winners that a long call or long put can, they will drastically reduce the cost of the trades and provide multiple ways of making money which will give us a more forgiving trade.
Whether you are buying a call or put option going into earnings or selling a credit spread, the key is to keep the risk small. Earnings plays in most cases will be all or nothing.
The trade will either be a nice winner or full loser overnight.
Don’t get caught going for the home run trades on every earnings trade. Going for the singles and doubles with the higher probability credit spreads can add up to a really nice return with far better odds in your favour.
We have traders that never take earnings trades and that is just fine. I will trade through earnings but like to keep the risk around 50% of my normal position size. This will allow me to stay active through earnings without large risk that can lead to big draw downs in the account.
Manage your risk through earnings and focus on strategies that will give you multiple ways of making money can produce a nice additional way of growing your account.