By: Steve Smith
Spread your wings with a butterfly strategy as a low risk way to earn big profits. This play gives you a wide range to realize large gains.
Making trades based on an earnings report poses several challenges but can deliver big rewards as the reports tend to cause large price moves. One not only needs to accurately predict what the company’s actual results will be but how these stack up to analyst estimates. Then you must determine how investors will react; has the stock run up ahead of the report and therefore vulnerable to a “sell the news reaction?”
One way reduce the risk, and hopefully boost the rewards, is to use options. But this means layering in what the options are already “pricing in” via their premiums. The premiums or price of the options are determined by their implied volatility. Implied volatility typically increases prior to the earnings report in anticipation of the market moving news, and then declines rapidly immediately following the release regardless of the price movement.
I refer to this as the Post Earnings Premium Crush or PEPC. PEPC can drive even experienced traders crazy and often leaves novices with unexpected losses. For example; often times someone will buy straight up calls expecting a stock to rally following a the earnings report. The results are better than expected and the shares do indeed move. But the value of the call options actually declines! How can this be?
The options might have been pricing in a 5% price move but the stock might have only moved 3% and the resulting decline in implied volatility or PEPC offsets the value increase of the underlying shares, or delta impact, leaving the option’s call value little changed or even down.
A recent example of this occurred in Target (TGT) which reported earnings on January 15th. The day before the shares were trading $75 and the $75 call which expired three days later was trading at $2.10 per contract. This implied that options were anticipating approximately a $2.10 or 2.9% move within the three days following the report. This was about how much Target shares have moved following its four previous reports. This means you would need the stock to be above $77.20 at expiration for the calls to turn a profit.
Shares did initially jump as high as $77.50 but within minutes they were back below $77 and finished the day at $75.70. Even though the stock was up 70c on the day the calls closed at $1.50 or down 60c on the day causing call owner to suffer a loss despite being right on the underlying stock movement.
This phenomena of pattern of spike then retreat in the implied volatility each quarter can clearly be seen in Google (GOOGL).
As you can see implied volatility has been climbing as the stock approaches its earnings this Thursday, January 29th.
The Butterfly Effect
All of this a big wind up to introducing an options strategy that not only eliminates the negative impact of PEPC but actually uses it to its benefit. The butterfly spread.
A butterfly is a 3-strike position that involves a combination of the following:
-The sale (or purchase) of 2 identical options
-The purchase (or sale) of 1 option with an immediately higher strike than the 2 identical
-The purchase (or sale) of 1 option with an immediately lower strike than the 2 identical
All options must have the same underlying stock, and have the same expiration date. One way to think of butterflies is as a combination of 2 vertical spreads — one bullish and one bearish — with a common middle strike. It has a 1 x 2 x 1 construction.
In the long butterfly, in which the two outside strikes are purchased and the “body”, or center strike, is sold for a net debit. This “stack of spreads” (one long, one short) creates a position that is initially both near delta and theta neutral and changes in implied volatility, have little impact on the value of the position. In fact, the high implied volatility or pumped up premiums allow you to establish these positions for a very low cost.
The maximum profit is achieved if shares are at the middle, or short, strike price at expiration as all option move to their intrinsic values. With the use of weekly options we can use a butterfly to create a position with a very attractive risk/reward in which the profits are literally realized overnight.
Google Going Down
Today, we’ll focus on how to use a butterfly spread to profit in Google (GOOGL) following its earnings report after the close on Thursday, January 29th. Shares of Google have been under pressure of late on concerns that its search advertising revenue is losing share as more people turn to apps on their mobile devices to find the products and services they need. There are also concerns it is spending too much money on “moonshot” products such as driverless cars.
With Google (GOOG) currently trading around $521 the options are currently pricing in about a $20 or 4% price move. Given that this earning season has seen stocks post large moves I want to target a slightly larger price move. Therefore I’m using the $490 as my target for maximum profit level. This is also the recent low which should provide a near term support level.
I’m using the weekly put options that expire this Friday, January 30th. The day after the earnings report.
-Buy 1 Jan. $510 put for $6.50 a contract
-Sell 2 Jan. $490 puts for $2.30 a contract
-Buy 1 Jan. $470 put for $0.50 a contract
This is a $2.40 net debit (The cost of the two puts purchased$6.50 + $0.50 = $7 minus the premium collected of the two puts sold 2 X $2.30 = $4.60,).
This $2.40 cost is the maximum loss and would be incurred if shares of GOOG are above $510 or below $470 on Friday’s expiration.
The maximum profit is $17.40 (calculated by the width between strikes minus the cost or $20 – $2.40 = $17.60) and would be realized if GOOG is exactly at $490 on expiration.
For each 1x2x1 spread you are risking just $240 for a potential $1,740 profit. That’s over a 7:1 risk/reward or a potential 1,300% gain.
Lesser profits can also be realized if shares are anywhere between $473 and $507, a nice wide 6.5% range, on expiration.
This is how a butterfly can turn into a beautiful earnings play.