Getting Ready for Speculative Plays In the Next Earnings Cycle
It is hard to hold stocks through earnings as you never really know which way the stock will run on that day. The company can destroy on revenues, but miss on profits, or have record profits, but guide lower. This can be frustrating. Very Very Frustrating. I find it hard to know which stocks to buy for a good earnings beat, or even if I should hold a stock through earnings.
As an option trader, I would like to structure a trade, a delta neutral trade, where I would profit if a stock exploded or imploded, as I am generally clueless in which direction it would go. I have tried using Straddles and Strangles on certain stocks that moved well through earnings, but generally they are expensive and you really need a huge move in either direction to pierce the break even points and make a profit. If the stock does not move much, the Implied Volatility of the Calls and Puts that make up the Straddle/Strangle dramatically drops, making the trade quickly unprofitable.
Let's Try The Short Butterfly!
In my neverending quest to find the best strategy for earnings, I have chosen the Short Butterfly to Papertrade to validate if the strategy works for me. The Short Butterfly is similar to the Straddle in that you need the stock to move boldly in either direction, but has a narrower break-evens. However, your profit is limited to the credit received for the trade(as opposed to the straddle which has unlimited profit potential for those super gains at earnings such as Netflix's(Nasdaq: NFLX) last earnings call).
Short Butterfly Structure
Using Calls, a short butterfly is the combination of a Bull Call Spread and a Bear Call Spread. You could use Puts as well for this Strategy. The way that I will construct this trade will be to Sell 1 Higher Out of the Money Call(A Wing), Buy 2 At the Money Calls(The Body), and Sell 1 Lower Out of the Money Call(Another Wing). Using everybody's favorite stock, Apple (Nasdaq: AAPL), trading at $450.81 on 2/22, here is how I would structure the Short Butterfly. I would use AAPL's weekly options that expire this Friday, March 1st.
Sell 1 MARW1 AAPL 460 Call
Buy 2 MARW1 AAPL 450 Calls
Sell 1 MARW1 AAPL 470 Call
This trade would result in getting a credit of $212, which is the most I could make on this trade. The Maximum loss would be $788 if the stock stayed between the break-evens on Expiration Day.
My Short Butterfly Earnings System - Papertrading it First
My earnings system using the Short Butterfly as the weapon will contain some guidelines and some rules. I have studied many stock charts, and have selected just a few to start. These stocks definitely move consistently during earnings, have Weekly Options, and tight bid/ask spreads(liquid options are a must!).
1. Use Short Call Butterflies, with a 1-2-1 Contract Ratio
2. Use Weekly Options if available
3. Open Trade 2 Days before earnings
4. Structure the body of the Short Butterfly to be closest to At the Money as possible.
5. Exit 2 Days after earnings
Stocks for this round of Papertrading:
Priceline (Nasdaq: PCLN): 2/25 after market close
JC Penney(NYSE: JCP): 2/27 after market close
Others in this system with unknown earnings date:
Blackberry(Nasdaq: BBRY), Netflix(Nasdaq:NFLX), Google(Nasdaq:GOOG), Apple (Nasdaq: AAPL), Amazon(Nasdaq: AMZN), Green Mountain Coffee Roasters(Nasdaq:GMCR), Linkedin(Nasdaq:LNKD), Intuitive Surgical(Nasdaq: ISRG).
In comparison to the straddle which I have been unprofitable in the past earnings cycles, the Short Butterfly has narrower Breakeven Points and Time Decay is in your favor. However, the trader is paying more in commissions than a straddle for the 2 extra legs in the structure. A Straddle has unlimited profit, while a Short Butterfly has limited profit(credit received for the trade), but better probabilities to profit due to the narrower breakevens. I will papertrade the Short Butterfly this upcoming earnings season to verify if it is a legitimate options strategy to use, and/or if my rules need some tweaking.
Options are not for everyone, and can be very risky without training or knowledge on how to use, trade, or invest in them. If properly trained, have excellent risk management skills, and discipline, Options are an excellent way to enhance and compliment your investing experience and skillset.
Disclosure: I am long AAPL, JCP, and GOOG options structuring trades using both Calls and Puts.