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What do Baseball and Options Trading Have in Common

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If you’ve been watching the Major League Baseball playoffs, you’re already familiar with how careful the players and managers are with every decision. Pitching changes, pinch runners, everything matters more.


A batter that might swing away at a 3-0 pitch during a random game in June is much more likely to take a look at that same pitch when post-season survival is on the line.


The same concept is at play when you’re trading options during earnings season. The
In the options markets, implied volatilities rise – making options more expensive – in the expiration cycles that include scheduled earnings reports.


When they first learn about options, many traders are naturally drawn to simply purchasing options outright, buying calls when they’re bullish and puts when they’re bearish. The limited risk/large reward proposition is comfortable and easy to understand. The most they can lose is the premium they paid for out-of-the-money options.


Unfortunately, they tend to find out that they lose that premium quite often.


The problem with simply buying options is that for the trade to become profitable, you have to be correct about not only the direction of the stock, but also the timing of the move. Many new options traders will buy calls on a stock they expect to rally, only to find that even though they were correct about the direction of the move, it doesn’t happen fast enough to make the trade profitable.


This effect is exaggerated around periods when a company is about to announce quarterly results, making the shares more likely to experience a move. The implied volatilities rise and the premium you stand to lose when purchasing options rises as well.


Let’s take a look at Netflix (NFLX - Free Report) , which is scheduled to report quarterly results on October 15th. Looking at the market prices for October and November expirations, we see that the October 275 strike calls – which are just slightly out of the money with the stock trading near $274/share – are trading about $15 which represents an implied volatility of 92%.


The November 275 calls which have more than quadruple the time to expiration (36 days versus 8) are trading at only about $18, at an implied volatility of 52%.


The reason is fairly clear. The front-month options will change in value the most if the shares move after the earnings announcement, so those options tend to trade at the highest implied volatilities. In this case, if you were to initiate a bullish trade in Facebook by buying the October 275 calls before the earnings announcement, the shares would have to rally more than $16 before you saw any profits on the trade.


After the market moving announcement, implied vols tend to collapse quickly. You might be disappointed to find that if the stock moves up quickly by $8 or $9, the premium in the 275 calls you bought (which expire only a few days later) falls to something very close to parity – the amount they are now in the money – rendering the trade a loser. Even though you were correct about the direction of the move in the shares, it didn’t happen with enough magnitude to make the trade profitable.


With volatilities in the 90% range, you have to be really correct about direction, speed and magnitude of a move to make a profit on long options.


When options are relatively expensive, you’ll want to look for trades where you buy and sell options in equal proportion. If you were to buy the October 275 calls but also sell the 285 strike calls for $11 – which are also fairly expensive – you would have reduced the maximum loss on the trade by almost 75%.


Of course, you’d also be reducing the maximum profit on the trade to $6 – although that’s still a tidy profit on a one-week trade in which your maximum loss was $4.


Here’s where the baseball analogy is especially appropriate. When option premiums are high, trying to hit singles and doubles is a wiser strategy than swinging for the fences. Trades that are only long options leave open the possibility of home-run profits, but you can also strike out swinging if you are incorrect about the speed or magnitude of the move.


When the stakes are high, baseball teams try to move runners around the bases and score runs. You should think of trading options in a high volatility period the same way. Do what you can to reduce your risk, try to make smaller moves with a higher likelihood of success - and live until the next round of the playoffs.

-Dave
 

Want to apply this winning option strategy and others to your trading? Then be sure to check out our Zacks Options Trader service.
 


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