Stocks & Commodities V. 31:4 (61): Explore Your Options by Tom Gentile

Explore Your Options by Tom Gentile

DOUBLE SPREADS

At a recent seminar, I was asked what might be the best way to take advantage of a stock that drops after an earnings disappointment. I knew what stock he was talking about — Apple (AAPL). Just a week earlier, I had created a case study for AAPL just after the earnings report. Here’s a typical post-earnings drop on a big-name stock, as well as one strategy to look at trading when this occurs.

Typically, post-earnings disappointments are not from good stocks. Companies post earnings outside of the daytime trading sessions, usually announcing after the market close or before the market opens. Often, this results in a gap occurring, as the stock will most likely drop. Unless you want to trade the after- or before-market sessions, as option traders we are limited to trading when the market opens in New York following the announcement. Because after- and before-market announcements give us an idea of where the stock will be trading during the next-day session, it gives us time to set up a strategy.

Typically, the option market gets stirred up right before an important earnings announcement, and implied volatility gets higher than average. After the announcement, the next session will usually see the stock price move, either up (for positive earnings announcements) or down (for negative), but option premiums will most likely fall either way. But there are rare occurrences when a stock drops, and the time premium in options will not fall as fast. This presents an opportunity for the option seller. But how do we sell premium and protect ourselves from unlimited risk? Spreading. And how do we create a trade that’s neutral in direction and risk? Double spreading!