Trade Review: Earnings Play Gone Wrong

08/23/2011 8:00 am EST

Focus: OPTIONS

Elizabeth Harrow

Financial Analyst, Schaeffer's Investment Research, Inc.

This real market example shows how an option spread strategy allowed one trader to limit losses when the market turned unexpectedly against them.

After last Thursday's closing bell, Salesforce.com, Inc. (CRM) reported a second-quarter profit of 30 cents per share, slightly improved from its year-ago earnings of 29 cents per share. CRM has met or surpassed Wall Street's consensus bottom-line expectations in each of the past five quarters.

From the numbers that crossed the tape, at least one option trader opened a position and hoped for another upside surprise.

Specifically, CRM was targeted by a call spread speculator on Wednesday. The trader purchased a block of 179 August 125 calls and simultaneously sold a matching block of 179 August 130 calls, resulting in a net debit of $2.40.

In the best-case scenario, CRM would have settled squarely at $130 at Friday's closing bell, reaping the maximum potential profit on the purchased call, while the sold call could be left to expire worthless.

The debit spread player's maximum potential risk was limited to that initial net debit of $2.40, but his profit potential was also inherently limited. The most he stood to gain on the spread was limited to the difference between the two strikes, less the initial debit, or $2.60, in this case.

As we now know, even with satisfactory earnings, CRM suffered with the rest of the market and closed last Friday just under $111. This position didn’t work out as planned by the trader.

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This trade shows the ease of using options to play a hunch on earnings while capping a possible loss, but also highlights the fact that even when earnings match expectations, the price action may not.

See video: Trade Earnings with Weekly Options

This trader was smart to limit their risk with a spread but is probably wishing they had played puts instead.

By Elizabeth Harrow, contributor, Schaeffer’s Trading Floor Blog

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