Earnings are typically an excellent time to “place your bets” and I prefer to do so via options. One of the most common option plays pre-earnings is the straddle or strangle where a put and call are purchased and whatever that net debit is is how far beyond the strikes the stock needs to move before the trade breaks even. Never really been a fan of straddles or strangles although they do have their place.
I prefer to be a premium seller, especially when stocks run up into earnings. I tend to sell premium at technical levels but that’s always a difficult task going into earnings. The preferred strategy is to sell an option then purchase a further OTM option for protection. You can do this with both puts and calls and create an iron condor and that’s what I prefer to do. Why? Well, to sell the calls and puts requires no more maintenance than just selling calls or puts. In fact, by selling both you can actually reduce your risk by taking in more premium.
Digging a bit deeper, let’s assume you sold a 100/105/75/70 iron condor on $RIMM for $1.35/contract. It’s a $5 spread so subtract the credit of $1.35 and you’re left with $3.65. That $3.65 is the risk in the trade and it might seem ridiculous to risk $3.65 to make $1.35. Stop for a moment though and think of the potential outcomes and it begins to make sense.
RIMM would need to move beyond $101.35 or below $73.65 in order to be at risk of losing in this trade. Take a look at the chart below and you’ll see what I’m referring to. Basically RIMM would need to break under it’s 50 DMA to hit the downside break-even and would need to move about 18% to hit the upside break-even. Yes, both are possible, but the catch is that it has to do it in the next 24 days.
You should also consider the implied volatility that would come out of these options as well as the time erosion. All of the premium in these options are extrinsic and that means they are made up of time and volatility. In other words, unless RIMM gets beyond the break-evens then there is no intrinsic value and the options expire worthless.
Now iron condors aren’t for everybody and they do require maintenance to keep the trade on. The amount of the maintenance varies but for a $5 spread like this you’d be looking at $500 per contract (minus your credit). If you prefer not to take this type of risk yet still define your risk going into earnings then you can buy a butterfly.