Earnings Trap Option Traders Must Avoid

10/18/2011 9:00 am EST

Focus: OPTIONS

Mark Sebastian

Founder, OptionPit.com

Recent market action before and after Google (GOOG) earnings proves that it’s often dangerous to sell options into an earnings report.

I often tell my students not to play earnings reports. Especially when the play is a Delta-neutral trade and the trader is selling premium. This is mostly because markets are really efficient when it comes to price movement. Take Google, Inc. (GOOG), which announced earrings after the bell last Thursday (Oct. 13).

Here is an after-hours quote that Thursday afternoon following the announcement:

Chart1

The stock was up over $35, but for those option traders who thought there was some edge in buying or selling options, take a look:

chart
Click to Enlarge

The 560 straddle was expiring the next day (Friday) and went out at almost exactly $35. The straddle play is a great measure for the markets expected movement on GOOG earnings. 

That is one efficient market. The reason I do not advise selling Delta-neutral options into earnings is because in the cases where markets are wrong about expected movement via a straddle price, it is not typically the stock moving less than expected; it is usually the stock moving more than the trader expects.  

I have seen more disasters in earnings premium sales than just about any other play. If the above straddle ends up losing, it is going to be from the short side.

Indeed, Google went to nearly $600 last Friday, but it has retraced since.

The best earnings plays are those that follow the smart money and pick the right direction—not always easy, but doable.

Experienced option traders are experts at reading an option chain and seeing where the institutions are lining up to buy or sell options for themselves. It comes from spending a lot of time watching the option chains and getting a feel for the behavior of a particular stock like GOOG.

By Mark Sebastian of OptionPit.com

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