Why Use Options During Earnings Season
First, look for stocks at or near proper buy points. Most will be building bases. After that, look for a slightly out-of-the-money weekly or monthly call option. This means the strike price is just above the underlying stock price. Every strike price comes with a premium, or the cost of the option. Divide the premium by the stock price, and multiply by 100; this gives you the downside risk for the trade in percentage form. Looks for trades with downside risk of 4% or less.
The strategy is detailed every week in the Earnings Preview column of the IBD Weekly print edition, on page B2.
NVDA example
One of the early winners since this feature's debut? Check out Nvidia (NVDA), featured in the May 9, 2016, edition of IBD Weekly as it got support at the 10-week moving average.
When shares were trading around 35.50 on May 12, a slightly out-of-the-money weekly call option with a 36 strike price (May 13 expiration) came with a premium of $1.27. That offered a trade with 3.6% downside risk.
Shares gapped up May 13 on earnings and closed at 40.98. The option could have been exercised that day at 36. If you didn't want shares, you could have sold the option itself for a nice profit.
Other winners that arrived in later weeks included Salesforce.com (CRM), Ulta Beauty (ULTA), Lululemon (LULU), Paychex (PAYX), Yum Brands (YUM) and Domino's.
Of course, earnings option plays aren't always going to work, but they're a lower-risk alternative to buying a stock outright ahead of earnings because risk is predefined.
Wells Fargo Stock Earnings Next Week; Options Market Helps Set Expectations
Calculating Expected Move On Wells Fargo Stock
The quickest way to work out the expected move is to look up the option chain and add together the price of the at-the-money put option and the at-the-money call option. We use the first expiration date after the earnings date.
While this approach isn't as accurate as a detailed calculation, it does serve as a reasonable estimate.
Let's take Wells Fargo stock as an example. Earnings are before the open on July 14 so we would use the option chain with a July 16 expiration. The at-the-money call and at-the-money put on Wells Fargo stock are trading just above and below 1.00. The sum of both is roughly 2.05 and that is the expected point move. With Wells Fargo stock trading around 42.50, that's about a 4.8% expected move.
Remember, that doesn't tell you direction. It could be either up or down!
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