Earnings season is like ‘March Madness’ for options traders. Here are some basic strategies

With earnings ramping up, we thought we would revisit our discussion about options and how investors might use them during this quarterly reporting season. If you haven’t read our prior work on the subject, take a look at our Zero-day options and our Basic options primer stories, as they will help establish the basis for what is discussed throughout this commentary. We also want to say upfront that the CNBC Investing Club does not trade options. Jim Cramer’s Charitable Trust, the portfolio we use for the Club, is long only. It’s designed as an investment vehicle, not a trading one, in hopes of giving lots of our profits to charity while educating Club members about how to invest and manage a portfolio. That said, in our mission to educate we do tackle popular investing and trading strategies, such as our technical analysis primer and our Super Six entry points to consider stories, that are common to the market as a starting point for members to better understand them and have enough information to start their own research and to assess their risk-tolerance. Options are inherently risky, especially for novices. Let’s look at some strategies investors might use ahead of this week’s flood of financial numbers either to augment an existing position or create a unique risk-reward via a multileg (meaning two or more options) strategy. Covered Call This is the most basic, and some would say safest strategy. The idea here is to sell your upside in exchange for money upfront. For example, if XYZ is trading at $190, one might look to sell a $195 strike call. Doing so means: a) you collect the premium, but b) you are giving up any upside beyond that $195 strike price (plus whatever premium you collected). The reason this one is of interest around earnings season is because of the elevated implied volatility (IV). More IV means more premium. And since, we’re selling a call here against a position we already own, the idea is to use that higher IV to our advantage by selling for a higher premium than we would normally get, all else equal, with the upcoming earnings release being the key variable. Implied volatility (IV) attempts to price in expectations of volatility in the future. Higher volatility adds value to both call options and put options. IV is pretty much always going to increase into a major event such as earnings, meaning there is a little more juice in both calls and puts come earnings season. It’s like “March Madness” for options traders. That means you’ll be paying up for any contract you buy or making a little more on any contact you sell, which may be too your advantage. That in mind, we’ll again focus on intrinsic value at expiration because at the end of the day, if you focus on this, you’ll begin to get a sense of the risk/reward without having to think too much about all the other metrics used to determine options prices and price swings. Say the premium is $2 on that $195 strike heading into earnings and I am sitting on 100 shares (remember every options contract represents 100 shares). I may decide that shares probably aren’t going past $197 (my breakeven). So, I can sell the $195 strike in exchange for $2 today. If shares don’t reach the strike by expiration, I keep the $2 and walk away with my shares. If, however, shares hit the $195 strike, then I am, as the seller of that option contract, obligated to sell my shares at $195. Whether I made the right choice to implement this covered call strategy is based on where shares land. If they land below $197 then I’ve still made money – remember my breakeven is $197 because I’ve sold shares at $195 and collected $2 ahead of time. If, however, they move past $197, I haven’t really lost money – after all, when I entered the contract the shares were at $190 and I’ve gotten out of them for $197 (the $195 selling price plus the $2 premium) – but I did leave money on the table (anything over my $197 breakeven). Say XYZ reported a good old fashion beat and raise while announcing a monster buyback and shares surged to $210. I don’t get to enjoy all of that because I’m out at $195 (or $197 if you include the premium). I’ve left $13 per share on the table ($210 market price less my $197 breakeven) while the person who bought the call from me got to collect on all the upside I’ve missed, $13 per share (from $197- the $195 they paid of the shares plus the $2 premium they paid to enter the contract – to the $210 price at which they could turn around and sell the shares in the open market). That’s the trade-off. For a “dividend today,” you’re selling your upside. For some that’s highly attractive because even if it’s called away, they feel they made some upside and that’s the focus more so than the money they left on the table. Also, if you can pull it off and collect the $2 without losing your shares, you can run that same strategy again and again until they’re called away (or until you no longer think it worthwhile). You can look at that as one of two things, either, you’re consistently reducing your cost basis – say I spent $187 on those shares initially, if I collect $2 and keep my shares, I might argue my basis is not $185 – or as a dividend – if can pull this off four times a year and collect $8 over the course of a year, in a stock I paid $187 for, I’ve essentially generated a 4.3% dividend payment for myself. It’s not a bad strategy especially for those concerned more about income and maintaining wealth than generating it. However, we don’t like the idea of giving up our upside. We do a lot of research before putting on a position and we only put it on with the view that we can generate outsized gains versus the broader market. The idea of giving that up for a small premium upfront simply is not attractive to us. Could you imagine if we went into Nvidia’s May 2022 earnings release with a covered call? Shares were about $305 heading into that release, even if we collected $30 (a 10% premium) for a $320 strike we would be kicking ourselves about it to this day as we would have been out of the name at $350 ($330 strike plus the $20 premium) only to watch shares close the next day at about $380 and not once offer us an opportunity to get back in at that $350 level. We aren’t in Club name Nvidia, or anything for that matter, just to sell the upside. That’s just not what we do at the Club. Put option overlay We’ve already discussed put options in a vacuum, however, we want to go over it from the perspective that you are buying a put option in a name you own. Let’s keep with our XYZ example, assuming shares are trading at $190. If I am concerned about the upcoming release, I may look to buy a put option as insurance – in this instance that’s exactly what it is and like with all insurance, you’re probably going to be more happy if you lose the premium without needing the insurance. Keep in mind though, just as we were able to sell the call contract above for a bit more than usual due to the increased IV, this insurance (put) contract is going to cost us a little more than it normally would. Why do you think auto insurance tends to be more for drivers under 25? Because they’re a bit more volatile and the odds of that insurance being needed is a bit higher than normal. Say I spend $2 on a $185 put option. If shares tank – because XYZ missed quarterly estimates, lowered guidance, and cut the dividend, causing shares to fall to $160 apiece, I’ve saved myself a great deal of pain because my ownership of that put option allowed me to sell shares to the seller of the contract at $185 (or $183 when accounting for the fact that I spent $2 on the premium). I’ve still taken the loss from $190 to $183, but everything beyond that is someone else’s problem. It’s not the worst thing to consider depending on the situation, such as if a stock is going into the print with nearly unbeatable expectations (though you should expect that to that to be priced into the premium via the IV). While we do keep all of our upside, you must be mindful that the premiums you’re paying for these put contracts erodes your long-term gains. Say for example, XYZ didn’t tank, I’ve given away $2 of upside, I do it again next earnings season and again the shares hold in, now my long-term gains are $4 less per share than they could have been. While you might be keeping your upside, the potential future gains, or any profits you’ve already made in the name, are being spent today. That’s a key reason we aren’t huge fans of put options for the Club. We invest for one reason, because we see long-term gains in a stock’s future, the last thing we want to do is start spending those gains before they even materialize. If we are that concerned about the upcoming event, we would prefer to trim the position or blow out of it completely — that not only reduces our risk but also provides us with additional cash on hand. Spreads A spread strategy is a multileg strategy in which you simultaneously buy one option contract and sell another at a different strike. The idea is to limit risk in exchange for reduced potential reward. There are several variations of spread, with some implementing contracts that expire at different times. However, for our purposes, we’ll focus on four strategies in which the expiration date remains the same for all contracts and only the strike prices change. This doesn’t do much to augment the risk/reward of an existing position in the way the strategies above would, but it does offer a way to play an earnings release with more defined risk/reward than what one would realize by buying or selling a put or call without an underlying position. The reason this strategy can be of interest around earnings season is due to that higher IV. When simultaneously buying and selling contracts, we can somewhat cancel out the cost of the elevated IV while still getting in on the action. On one hand, we are buying a pumped-up option that’s selling at a higher level than it would otherwise because of the increased IV into an earnings release. But, on the other hand, we’re also selling a pumped-up option that’s selling at a higher level than it would otherwise because of that same dynamic of an increased IV being price into the option contract. Bull Call Spread: “Bull” in the name tells you that you’re playing for a higher stock price and “call” tells you that you’re going to implement this strategy using call options. The idea is to profit from a move higher but reduce our premium (risk) in exchange for capping the upside. This done by simultaneously buying a call and then selling another call at a higher strike price. Say we think XYZ is trading at $190, and we think it’s going to make a move higher. We may look to simultaneously buy (go long) a $190 strike call for $3 and sell (go short) a $195 strike for $1, resulting in a net outlay of $2 ($3 paid less $1 received) and a breakeven of $192 (in at $190 plus the $2 premium). What does that get us? Starting with the $190 we purchased, if shares move higher, we get to buy them at $190 thanks to that first leg (the long call at a $190 strike), however, because we also sold a call at $195, those shares we take at $190 can be taken from us at $195. Put another way, we get to enjoy the ride from $190 to $195 (a $5 ride). Of course, we paid to $2 up from to take this ride, so in the end our maximum profit (attained if shares reach $195 or above) is $3 (that’s the $5 made from $190 to $195 less the $2 spent upfront), or 150% ($3 profit divided by the $2 initial outlay). At the same time, if the strategy doesn’t work out and shares decline in price, we’ve only lost $2, not the $3 we would have (50% more) had we decided not to sell that $195 strike. Bear Call Spread: As “bear” implies, here we are betting on shares declining in value. To implement, we would do the opposite of “Bull Call Spread,” and sell the $190 strike while at the same time purchasing the $195 strike. Using the same premiums noted above, we would actually be collecting $2 in premium by selling the $190 strike for $3 and buying the $195 strike for $1 apiece. The idea here is for the stock to decline and for us to walk away with that $2 premium. Say we are wrong and shares move up to $195 or above. In this case, we’ve limited our risk by purchasing that $195 strike (that’s our insurance). The reason being, if shares move higher, the buyer of that $190 call will come knocking on the door for us to sell them shares are $190 (as is their right as holders of the call we sold them). However, because we bought a call at $195, we can go knocking on someone else’s door to collect shares at $195 (no matter how high they go), as is our right of the owner of the $195 strike call. We got the play wrong but our losses are capped at $3, the $5 we lose buy purchasing shares at $195 and selling them at $190, partially offset by the $2 we collected upfront when the strategy was first implemented. Again, our breakeven is $192 as we may need to deliver shares at $190 but we also collected a $2 premium ahead of time). Bull Put Spread: As in the case above, “bull” tells us that we profit from a move higher while “put” implies that we will use puts to implement the strategy. To implement this strategy, you would sell a put at a higher strike price and then purchase another put as insurance at a lower strike price. Say for example, shares of XYZ are trading at $200, we may look to sell a $195 strike put for $3 and buy a $190 strike put (this is our insurance) for $1 apiece. If shares move higher, then we keep the $2 premium we collected ($3 collected for selling the $195 strike less the $1 paid to buy the $190 strike put). If, however, they move lower, say to $180, then we’ve lost $3, because the person that bought our $195 strike will force us to buy their shares at $195, which we will then in turn force upon the person that sold us the $190 strike put. We’ve lost $5 on the move from $195 to $190, however, that was partially offset by the $2 collected upfront. Our breakeven of $193 because shares can be sold to us at $195 if they move lower, but we also collected $2 upfront. Bear Put Spread: “Bear” implies a bet betting on shares declining in value. Also, as was the case with the call examples, to implement this strategy we simply do the opposite of what we did to implement the “Bull Put Spread,” and sell the $190 strike put and simultaneously purchasing the $195 strike put. If selling a $190 strike call, it means the buyer can sell me the shares are $190 and if buying the $195 put, then I have the right to sell the counterparty shares at $195 apiece. In this case, we would be laying out $2 (paying $3 to buy the $195 strike and collecting $1 by selling the $190 strike). If shares decline as we except they will, say to $180 a piece, then the buyer of our $190 strike put will demand we buy the shares at $190 and we will then turnaround and flip them to the one that sold us the $195 strike contact. We would make $5 on the trade (buying at $190 and selling at $195), partially offset by the $2 initial outlay. If, on the other hand, shares rally, then we’ve simply lost the $2 premium. So, basically, we’ve risked $2 to make a maximum $3 on the trade. In this scenario our breakeven is $193 because we can be force shares on the seller of the $195 put options, offset by the $2 premium upfront. One thing to consider in all of these scenarios is that shares could end up in between the two strike prices. In this case, you won’t have realized the maximum loss or gain but whether you made a profit or took a loss will depend on where exactly shares land versus the breakeven. Bottom line In the end, these are some of the ways investors and traders may look to play earnings releases via the options market, and we are providing this information because we’ve gotten a lot of questions about options in the past. While the Club does not engage in options trading, we still wanted explain some of the more popular strategies as part of our goal to educate. In terms of the call and put overlays noted above, the Club does not like the idea of giving up our upside or slowly chipping away at longer-term gains via put premiums. As for the spreads, these strategies are largely independent of your equity holdings – and as a result, don’t do much in terms of risk/reward augmentation. They’re simply ways to play an event while strictly defining you risk/reward ahead of time. Lastly, options are just a tool and must be fully understood before being implemented. The risk/reward profile is completely different than investing in just stocks. To be successful with equities, you just need to determine if the stock will go up, buy it, and wait while doing your homework to stay on top of the position. Jim Cramer calls it buy and homework . With options, you need to get the direction, timing and magnitude of the move right. Missing on any one of these can result in losses. These tools are not appropriate for everyone and that’s fine, the most important thing we can do as investors is “know thyself.” Do not get caught up in the hype of these more exotic instruments without fully understanding the risks of each strategy. One more thing To borrow from the way Steve Jobs (and now Tim Cook) ends each Apple event, we want to leave you with a top-level look at what’s known as “The Greeks,” a set of measurements used to value options. To scratch the surface, here is a very (and I do mean very) simple way to think about the four main Greeks. Delta measures the rate of change in option price for a $1 move in the underlying security. So, if the delta is 0.30, expect the price of the option contract to move 30 cents (direction depends on if it’s a put or call) for every $1 move in the underlying, all else equal. Theta measures time decay. There are two high-level factors that determine an options price, intrinsic value and time value. As options approach expiration, time value moves toward zero. Theta measures this decay. So, is an option has a theta of 2, expect that option price to decline by $2 per day, all else equal. Gamma – measures the rate of change of delta. In the above definition, we said “all else equal” but of course that’s not what happens in reality. If the price of the stock moves by $1, then it’s either moved closer to or further away from the strike price (along with the passing of time and whatever else may have happened to cause that move). That change will result in a change to the delta value. Gamma attempts to measure how much delta will change based on a $1 move in the underlying security. Vega – measures how the price of the contract will change based on changes in excepted volatility. There are other Greeks, a notable one being Rho , which attempts to measure the impact a change in interest rates will have on options prices. However, the four noted above are the main ones most traders will focus on when placing trades and where you should start if you want to go deeper down the options rabbit hole. (Jim Cramer’s Charitable Trust is long NVDA, AAPL. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

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