By Brad Tompkins
Since we’ve now entered another earnings reporting season, I thought I’d take the time to layout a nice options cash flow trade. The basic strategy is a Put Spread Collar which pairs a covered call with a protective put spread. For this exercise, we’ll look at an Apple options trading idea.
The goal is to take advantage of the extremely high volatility leading into the earnings announcements by selling the rich call option premium. In addition, take a small amount of the collected call premium to buy a put spread which gives downside protection to a support price area at which we’d be willing to hold the stock outright. Most times these trades tie up capital for a very short time going on within a day or two before the report and exiting within days after.
Company Filter Criteria
The company filter to find eligible stocks is pretty simple but investors need to be discriminating so as to only take on trades when all the odds are in your favor.
- Large cap company with better than average option liquidity and ideally option contracts expiring within days after announcement
- Option premium for at the money calls > 2% (extrinsic value divided by stock price)
- Stock trading near clearly defined long term technical support area. Stocks that have already run higher into earnings are excluded. Also a plus if the PE valuation is not stretched.
Mechanics of a Hypothetical Apple Options Trading Idea
Apple (AAPL) is one of the better setups meeting the filter criteria. They report on the Wednesday January 23rd after trading hours so I’ll be looking at the weekly options that expire Friday January 25th. We can run through the numbers as if we’d placed the trade at Friday 11th closing prices and then project the results for holding the position through the 25th. Keep in mind to adjust the option strikes if the stock price moves away from the $520 current level.
The trade profits by selling the nearly 4% (19.90 / 520.30) of option call premium and uses about half of that (9.20 = 15.00 – 5.80) to pay for the put spread offering significant downside protection. As in any covered call position, we have a fixed profit cap (same $10.70 profit whether AAPL trades 525 or 625). On the downside we get to offset our share purchase price with the net collected option premium ($10.70), as well as with the put spread distance ($30 = 510 – 480). This ultimately gives us a calculated breakeven price of $479.60 (520.30 – 10.70 – 30.00). This is closer to the long term weekly trend line support, a pricing area where I’m comfortable owning the shares outright.
Update: Because Apple’s stock gapped lower on Monday at time of publication, Brad Tompkins tweeted another potential scenario as of Monday’s close. Click here to see his tweet.
Legging into the Trade
A slight tweak to the strategy is to separate the Apple stock share purchase from Apple options trading if we can jump a momentum move while the stock is in our crosshairs in its pre-earnings trading window. I don’t have any solid data to back this up, but more often than not there will be at least one nice tradable intraday pop higher. In any case, normal trading rules apply: momentum thrust entry signal and regular stop loss point. The difference is that instead of looking to take profits with a trailing stop or at a target price, put on the collar option combination instead of exiting the trade and selling off the shares. It’s a nice way to boost the profits by leveraging this tendency to trade higher into earnings.
Cautions to this Apple Options Trading Strategy
Lastly, I’ll give you these cautions to consider. Price fluctuations around earnings announcements are extremely difficult to predict. This strategy creates a somewhat binary outcome where it profits as long as there isn’t a drastic loss in the stock price. It is not a strategy to be used if you have a confident directional bias. You will need to have a contingency plan if the stock disappoints and trades down below the break-even. Likewise, don’t try to get cute and attempt to squeeze out additional gains if the stock trades significantly higher. Just close out the entire position and then revert to normal directional trades if you want to continue playing the stock move. Apple options trading is likely to be volatile heading into the report. As with any option trade, be aware of expiration dates and assignment risk (especially if ex-dividend date is near). Also make sure you have authorization to trade option spreads in your account.
Have a plan. Trade it well.
Position in Apple (AAPL) at the time of publication.
Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.