Trade Earnings By Selling Option Premium

Method 3 – Selling Option Premium Just Before Earnings Announcements

 

Trading earnings announcements is an excellent one to add to your arsenal for a number of reasons. Option premium inflates right before companies report their earnings numbers. This means option sellers stand to gain if they trade earnings on quality dividend growth companies. Let’s go through a few examples where traders can trade earnings announcements. One can either scale into a stock, sell a position or just make stand-alone income.

Disney announces its quarterly earnings on the 8th of August 2017 after market close. The volatility chart below was downloaded a day earlier (08-07-2017) which confirms why the stock currently has high implied volatility. Let’s say for arguments sake, one currently holds the stock as its a quality dividend growth stock with strong competitive advantages. However the company’s present earnings multiple is 18.8 (current share price around $107) which is only slightly below Disney’s five year average of 19.6. This means a spike up in the share price to $112+ post earnings brings Disney back to its average earnings multiple over the past 5 years. We calculate this by multiplying 19.6 by Disney’s current EPS of 5.74 which works out to be $112.5. This is only a 4.6% move from the stock’s current price which is definitely achievable with an earnings trade.

Sell Premium Aggressively When A Stock Is Becoming Overvalued

Therefore all one has to do (if they want to potentially have their shares called away) is to the sell some calls in the front week. I favor the front week as implied volatility is higher. This is when implied volatility should be at its highest and where you can eke as much premium as you can out of the call options. This strategy is basically the same as a covered call but over a much smaller duration. Anything from 1 to 4 days. The shorter duration of this strategy and the volatility crush that takes place once the numbers are big advantages. They enable options sellers to put on more high probability trades over the long term.

Just sell the strike price you would be comfortable with. Earnings announcements can sometimes cause a big move in the underlying shares depending on the magnitude of the earnings beat/miss or guidance changes. This strategy is a win/win scenario in the sense that if the stock sells off, you still hold a quality dividend growth stock after the announcement. One which trades below its average valuation but you still pocket the option premium. On the other hand, if the shares get called away, they do so at a respectable valuation. One can then seek out cheaper alternatives and rinse, wash & repeat.

Trade Earnings – Implied Volatility of Disney 1 Day Before Announcing

Image of Implied Volatility of Disney 1 Day Before Earnings

Trade Earnings – Call Options Chain in Disney. Stock Trading Around The $107 Mark 1 Day Before Earnings

Trade Earnings - Image of Call Options Chain in Disney Before Earnings

Trade Earnings Also To Scale Into Cheap Dividend Growth Stocks

Furthermore what if one could trade earnings announcements to buy quality dividend growth stocks also? Well one can by selling put options again just before the respective company in question announces its numbers. In fact there are fewer strategies that are more powerful than selling puts on quality stocks. Why? Because you can pick up the respective company for a cheaper price than it currently trades at. For example in Disney at present, if one didn’t hold the stock, by selling the $104 put that expires in 4 days, one collects $67 per contract plus the possibility of stock being assigned at that very strike price.

Assignment of shares at $104 constitutes an earnings multiple of around 18. Remember at the time of writing, Disney‘s 5 year average earnings multiple is 19.6. Selling puts (as long as they are being sold on quality underlyings) is an excellent strategy in a high implied volatility environment. Trade earnings both to scale into stocks or to liquidate holdings. You will be pleasantly surprised with the results.

Option Put Chain Prior To Earnings

Trade Earnings - Image Of Put Chain In Disney Prior To Earnings

The Hybrid Approach To Investing

The approach in these examples is a hybrid approach to investing and trading. Many times both traders and investors under-perform their expectations. The reason being they stick too rigidly to a given system. The philosophy in these examples is to trade earnings rigorously around quality stocks to maximize income. Yes sometimes one will be either assigned stock or one will lose stock on earnings plays. This though is the name of the game with this strategy. It is all about scaling into stocks when they trade on the cheap and look to exit when they become too expensive from a valuation perspective.

For example, if I am put stock ( after selling put options), I may hold this underlying for years. I will then simply collect the dividends until the position comes back into the black. This is why you have to focus your efforts on companies with strong competitive advantages. One must have their fundamental analysis done on the given company before entering the trade. The goal in your portfolio should be to never have “weak positions” because they are the ones one invariably sells first when the going gets tough.

Remember Success Is 80% Mindset & 20% Mechanics

Some investors can have a 30 year horizon or more. With traders it can be anything from a minute to 6 months. With strategies such as these, it is a hybrid of both short & long term investing. One can hold stock indefinitely but one can also take profits on an option position within days. Don’t get tied into the “monthly income” mindset as some of your positions will take far longer than a month to work themselves into profit. Do the right things. Trade earnings with the end in mind and remain ultra patient. The market has to participate but ultimately this is a game against yourself which over time is yours for the winning if you consistently do the right things.

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