U.S. Markets closed

Earnings Trades Revisited

David Borun
Stanley Black & Decker's (SWK) second-quarter 2019 earnings to gain from buyouts, pricing actions and innovative capabilities. However, risks from tariffs, forex woes and commodity inflation persist.

Earnings season is upon us once again, so let’s revisit this discussion of options trading fundamentals.

Options trading is often considered a “zero-sum” game in the sense that whatever any trader makes, another trader must have lost. Technically this is true because each option purchased has to have been written (sold) by a counter party. If both traders hold the position until expiration without making any other trades, they will exchange shares of stock and/or cash and one of them will make exactly as much profit as the other lost.

In reality, this is rarely the case. Usually, one or both parties engage in more transactions over the life of the contract that significantly affect the profitability of the trade.

Let’s take another look at a trade that’s popular around earnings announcements that could actually end up being profitable for both sides:

On Wednesday, Lam Research (LRCX) was trading around $139.50/share and was scheduled to announce quarterly earnings after the market close. Investors were focused not only on sales and net earnings numbers, but also on the guidance the company would issue for the next quarter and full year 2019.

In the options markets, the 140 strike call and 140 put expiring February 15th were both trading around $7.00. The price of the straddle – buying both one call and one put – implied that traders thought Lam Research shares were likely to move $14 in either direction after the earnings announcement. These were very expensive options - even prior to a major announcement - as the shares would have to move more than 10% before the buyer saw a profit.

Just as we saw six months ago with Amazon (AMZN), the options actually may have been too cheap.

After LRCX announced a great quarter, raised guidance and announced a $5B share repurchase program, the stock rallied more than 14% to $160/share

The buyer of the straddle now has chance to lock in a nice profit. He can sell 100 shares of stock at $160, lock in a profit of $600/spread and still own 2 140 puts

For those of you saying “Wait, he only owns one put…” consider this. He owns one 140 call, one 140 put and is short 100 shares of stock. If we stay above $140 between now and expiration, he will exercise the call, buying the shares and the put will expire worthless. If the shares break below $140, he will not exercise the call and will exercise the put instead, making him short 200 total shares – just as if he owned two puts.

Long one call + short 100 shares = long one put.

The seller of the straddle may have felt the need to hedge the short trade by buying the shares when the stock was up sharply, in which case he has the opposite position as the buyer – a locked in loss and the risk of being short 2 140 puts.

If he didn’t hedge, however, he is basically short 100 shares of stock right now - from the 140 call he sold that is now significantly in the money.

He also currently has a mark-to-market loss of $700. The 140 call he sold is now trading $20.50 and the 140 put is trading $0.50, so if he bought them back in the market, he’d pay a total of $2,100. Having collected $1,400 on the straddle sale, that leaves a $700 debit.

The options have slightly more than 3 weeks until expiration.

If the straddle seller were instead to wait until closer to expiration and the stock declines over that period, he could potentially cover that $700 loss and even make money on the trade. If the stock sells off and he purchases 100 shares for $150/share and two 140 puts for $1.00 each, his position would be closed and he’d see a profit of $200.

In fact, if the stock were trading $150 and the 140 strike puts were trading $1.00, the straddle buyer could sell two of them and increase his total profit to $800 and still have no risk.

Both traders would have made a profit.

The lesson from this trade is that trading options – especially short term options around a scheduled event like earnings announcements – can be profitable whether you’re long or short and even right or wrong as long as you’re vigilant about which opportunities exist to hedge the trade to maximize gains and/or mitigate losses.

More Stock News: This Is Bigger than the iPhone! It could become the mother of all technological revolutions. Apple sold a mere 1 billion iPhones in 10 years but a new breakthrough is expected to generate more than 27 billion devices in just 3 years, creating a $1.7 trillion market. Zacks has just released a Special Report that spotlights this fast-emerging phenomenon and 6 tickers for taking advantage of it. If you don't buy now, you may kick yourself in 2020. Click here for the 6 trades >>

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report
To read this article on Zacks.com click here.
Zacks Investment Research