Bearish Outlook Over Earnings – a Possible Strategy

Option traders are generally told to stay away from earnings announcements. Why? -Because they can be very unpredictable and cause a winning trade to become a loser with either a good or bad report. Also, implied volatility is usually inflated for the expiration month that is closest to the announcement, especially on volatile stocks. Option buying can be difficult enough without also having to worry about if they are over-priced.

But what if an option trader has a notion that this stock is going to drop after the announcement, how can money still be made without risking a lot? One strategy could be to buy an at-the-money (ATM) or just slightly out-of-the-money (OTM) put option. The only possible problem with this idea is that those put options can be awfully expensive right before the announcement. After earnings, implied volatility often shrinks and so does the value of the puts. If the price of the stock doesn’t exactly drop as predicted or goes the other way, more money might be lost than originally intended. Another strategy could be to buy cheap OTM put options. The problem with cheap OTM put options is that they are cheap for a reason. More times than not, they are going to expire worthless. Basically the option trader is hoping and praying for a homerun.

A better alternative may be to buy a bear put debit spread. A bear put spread involves buying a put option and selling a lower strike put option against it. The cost of buying the higher strike put option is somewhat offset by the premium received from the lower strike that was sold. The maximum gain on this spread is the difference in the strike prices minus the cost of the trade. The option trader will realize this maximum gain if the price of the stock is lower than the strike that was sold at expiration. The most the option trader can lose is the cost of the spread. This maximum loss will occur if, at expiration, the stock is trading above the put that was bought.

If the bearish position is held through the earnings announcement, the option trader has the advantage of almost neutralizing implied volatility because puts were bought and sold. The downside to the strategy is that maximum profit is capped.

Dan Passarelli

dan@markettaker.com