Earnings season and options spreads

07/21/22
  • Options calendar spreads are designed to benefit from time decay
  • Strategy is neutral about the underlying stock’s direction
  • Earnings season may not offer ideal conditions

Options can sometimes allow traders to take different roads to the same destination. Buy an at-the-money (ATM) call and sell an ATM put, for example, and you have a trade with the same risk-reward profile as a long stock position.

But all roads are not created equal, even if they appear to be at first glance. When you’re driving, the shortest route may not be the fastest, and the fastest may not be the “best”—would you want to save five minutes by taking a crumbling road that could destroy the suspension on your new car?

That’s something for options traders to think about during earnings season. Different roads, different risks. For example, the calendar spread is designed to take advantage of one of the fundamental characteristics of time decay—the tendency for options with less time until expiration to lose value faster than those with more time until expiration.

Say a stock is trading at $75. A $100 call expiring in one week may have very little value—and will lose whatever it has very quickly—because of the small probability the stock can rally 33% in such a brief period. But a $100 call expiring in three months will have more value—and will lose that value at a slower rate—because the longer time window increases the odds the call will be in the money at expiration.

That’s the basis of the typical calendar spread, which combines a short ATM call option in a nearby expiration with a long ATM call option with a later expiration. Here’s what the position’s risk profile looks like:

Chart 1: Calendar spread risk-reward profile. Neutral about price direction.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


The short call should lose value faster than the long call because it’s closer to expiration—creating a net profit when both options are liquidated—but the passing of time isn’t the only factor at work here. As the risk profile shows, the position’s potential profit is greatest if the stock is still trading at the options’ strike price at expiration. Too big a move in either direction will result in losses.

If this risk profile looks familiar, that’s because it's very similar to the profile for a short strangle, which typically combines a short ATM call and a short ATM put with the same expiration:

Chart 2: Short strangle risk-reward profile. Different structure, similar profile.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


Like the calendar spread, the short ATM strangle benefits from as little price movement as possible in the underlying stock—which is just another way of saying these spreads are short volatility. Both are neutral about which way the underlying stock may move, as long as it doesn’t move too much.

If you’re wondering what that has to do with earnings season, consider this chart:

Chart 3: Netflix (NFLX), 1/11/22–7/20/22. Netflix (NFLX) price chart. Earnings volatility.

Source: Power E*TRADE. (For illustrative purposes. Not a recommendation.)


Netflix (NFLX) jumped 7.6% intraday on Wednesday after releasing earnings Tuesday. That’s a pretty big move, but it’s a blip compared to NFLX’s two previous post-earnings moves, -35% on April 20 and -22% on January 21.

True, those moves may have been much larger than average, but the lesson is that volatility surges should be expected during earnings season, which means traders need to be cautious about using strategies that depend on low or declining volatility to succeed.

After all, potholes can always appear unexpectedly, but when you know a stretch of road is likely to be bumpy, it’s often a good idea to consider another route.

Market Mover Update: Carvana (CVNA) extended its rebound Wednesday, rallying more than 18% intraday (see “Taking volatility for a test drive”).

Today’s numbers include (all times ET): Weekly Jobless Claims (8:30 a.m.), Leading Indicators (10 a.m.), EIA Natural Gas Report (10:30 a.m.).

Today’s earnings include: American Airlines (AAL), Danaher (DHR), Travelers (TRV), AutoNation (AN), D.R. Horton (DHI), Fifth Third Bancorp (FITB), AT&T (T), Philip Morris (PM), Union Pacific (UNP), Snap (SNAP).

 

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