Trade Earnings with Weekly Options

10/10/2011 8:00 am EST

Focus: OPTIONS

Joe Kinahan

Chief Market Strategist, TD Ameritrade

Trading stocks during earnings season can be risky, but Thinkorswim’s Joe Kinahan explains that weekly options are highly effective vehicles for trading earnings while still managing risk.

Earning seasons always bring a lot of volatility to the stock market and other markets. How do you use options to take advantage of what may be happening?

Our guest today is Joe Kinahan to talk about that. Joe, how can I use options around earnings seasons to limit my risk but take advantage of some of that upside as well?

Well the options exchange has come out with a great product recently to use for that, and that’s the weekly options. There’s an expiration every single Friday.

The reason I like them so much is because there is such a short time frame. Say earnings are on a Wednesday in a stock, and you think the stock is just going to explode, but you’re not sure which way. You can buy an in-the-money call or an at-the-money put and just hope that really good news or really bad news comes out; who cares which one, you have your position.

Now, once the news comes out, it’s time to get out of the position; it’s over. You played it for news, get out of the position. Hopefully you’ve made money, but if you haven’t and you get out, you lick your wounds, so to speak, and go on.

The problem that some people have around earnings is if there isn’t a weekly option, they play the monthly options. Nothing wrong with doing that; the problem people have is say it’s the first week of the month that earnings come out; the news comes out, they’re wrong, yet they still hold on to the position.

Weekly options force you to be a little bit more disciplined because if you’re playing for an event, get out after the event happens. Don’t go from being a trader to being an investor if that wasn’t your original intent.

Now if a company announces earnings after the close and somebody wants to get in perhaps that afternoon before they do, what kind of strike price should they be looking for? Something right in the money already, or out of the money; what do you recommend?

When I buy things, I like to buy things that have some value to them. When I sell things, I like to sell things that have zero value to them, or no intrinsic value, they’re not worth anything if they expired that day.

With that being said, particularly if I’m selling, I want to make sure I define my risk, so I’ll sell on a spread fashion so I know how much money I can lose if things go awry right away.

There’s no right answer to that question, necessarily. As long as you know on any of those scenarios what the worst-case scenario is, you can do a credit spread, you can do a debit spread, whatever it is you may prefer.

Again, the biggest caveat to me is once the event happens and you’ve played for an event, right or wrong, it’s time to get out.

That’s really a discipline that I think people will find more important than necessarily having exactly the right strategy.

Earnings season presents a little bit of a quandary for traders, because often times the move is made before the announcement altogether, and then even if they announce terrific earnings and meet Wall Street expectations, the stock inevitably goes down because the people are taking their profits, or it just doesn’t react the way you think it will.

Well it’s so often the statement that follows earnings. We see this so often. The top line, or that is, the number the Street expected, if they were expecting 20 cents, maybe it’s 21 cents, but then the CEO in his conference call says “Well, this was a good quarter, but next quarter might not be so good;” and then the stock gets slammed.

That is tough, it’s tough to predict what the CEO sees for their business, and it’s why you don’t want to play every stock for earnings, too. You want to get really familiar with a couple so you have a better idea of what’s going to happen.

So you recommend no matter what you’re doing, you’re always hedging in some way with the spread type of trade?

Yeah, I think it makes a lot more sense again to always define your risk up front.

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