When a trader is making a trade based upon an upcoming earnings report the first thing that they will look at is the at the money (ATM) straddle in the expiration cycle that is closest to expiration. The earnings report for Facebook (FB) is being released this afternoon on July 29th at 4:00 pm ET, immediately after the close. There are weekly options that expire two days later on July 31st. With FB trading at 95.50 let’s take a look at the FB Jul 31st 95.5 calls and puts. The market for the calls is 3.80-3.90 and the put market is 3.80-3.90. The straddle market is 7.60-7.80. The market is implying that FB will be trading between 87.80 and 103.20 over the next two days. The implied volatility (IVOL) for the straddle is 121.57%. At the most basic level when a trader believes that the range will be narrower then they will sell the straddle and if they believe that FB will trade outside of that range then they will buy the straddle.
Short StraddleLet’s look at the previous four earnings reports for FB on April 22nd and January 28th of this years as well as October 28th and July 23rd of 2014. On April 22nd FB closed at 84.6. The following morning the stock opened at 84.10. On January 28th FB closed at 76.24 and opened at 76.85 on the 29th. Both of these earnings reports were devastating for a long straddle position. On October 28th of last year FB closed at 80.77 and opened the next morning at 75.45. On July 23rd, 2014 FB closed at 71.29 and opened the next day at 75.96. The 2014 earnings reports that we’ve looked at had much bigger moves than the ones this year but they still were not bust out moves. Going long the straddle still was not a winning proposition. There is also a major problem with a short straddle position. That problem is excessive margin.
Another strategy that benefits from a small post earnings move is the long time value spread. With this strategy a traders sells the nearby options and buys further out options of the same type (put or call) at the same strike price. With FB trading at 95.55 going short the FB 95.50 calls that expire on July 31st while going long the 95.50 calls that expire on the 21st of August makes sense. The market in the nearby calls is 3.65-3.70 while the market for the further out calls is 4.35-4.45. The expiration value for both calls is 0.05. The difference in their respective premiums is comprised entirely of time value, in this case 0.80. The IVOL for the further out calls is 48.19%, much less than half of the near term IVOL. Traders are willing to pay 3.65 for the nearby calls for less than three days use. If the nearby calls expire worthless then a trader can own the farther out call for only 0.80 for three weeks use should they buy the time value spread. The rush to buy the nearby calls inflates their price relative to the further out calls. If there is huge move then the spread will narrow to less than 0.80. You will be left with a far out of the money (OTM) call to the downside or a far OTM synthetic put to the upside. The good thing is that you have defined your maximum possible loss while standing to profit handsomely should there be a small after the earnings release.