Simple strategy reaps massive profits on earnings

How to make massive profits on earnings
How to make massive profits on earnings   

It's been a great earnings season for options traders.

A few weeks ago, Goldman Sachs' options research team looked at the historical returns that would have been yielded by a strategy of buying at-the-money call options on stocks five days before their earnings, and selling them the day after.

Since a call represents the right to buy a stock for a certain price within a given time, this is a bullish strategy that would tend to profit as a stock rises. And since the average stock rises on earnings, those call options tend to pay off, Goldman found.

Generally, the strategy has yielded a profit of 14 percent, and 16 percent when it comes to stocks with liquid options. But as it happens, the first 38 companies with liquid options that have reported earnings have shown call buyers a return of 48 percent, tracking for one of the best years in Goldman's study going back to 1996.

Contributing to the bonanza for options traders have been names like Phillip Morris and Netflix, which would have shown call buyers profits of 793 percent and 538 percent, respectively.

More recently (and outside the timeframe of the Goldman note), the 380-strike call on Amazon expiring in May was trading for about $17 on April 17. On Friday, Amazon shares rose 14 percent on earnings, and as of the close, that same call was worth $66.15. That's a 290 percent profit in a week.

Of course, not every name soars on earnings. But Goldman's point is that because investors tend to be skittish and expectations tend to be overly bearish, stocks rise off of earnings more often than they fall, and the values of call options rise along with them.

However, buying calls outright ahead of earnings may not be the best strategy, some traders warn.

"While the vast majority of positions that we have put on ahead of earnings have been bullish positions, we rarely trade them using outright long calls," commented Andrew Keene, an options trader with Keen on the Market. "The uncertainty surrounding an earnings release creates a huge bid for implied volatility ahead of the release. Once the earnings come out, volatility drops, and this can hurt long options positions."

To reduce the effect of falling options prices on his positions' values, Keene chooses to use "spread" trades, whereby he sells options at the same time he buys them. That reduces his exposure to the overall prices of options ahead of a highly anticipated event.

However, the downside of doing a spread is that one often only captures part of a massive move, rather than getting the unlimited upside.

CORRECTION: This version corrected the percentage of profit in the Amazon options trade to 290 percent.

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