Big tech and “custom” options spreads

  • Many big tech companies report earnings next week
  • MSFT bounced in the past week after 2-month downswing
  • Ratio spreads tweak option strategies’ risk-reward profiles

Traders are just days away from one of the most closely watched portions of the market calendar—big-tech earnings.

Along with Alphabet (GOOGL), Apple (APPL), Amazon (AMZN), and Meta (META), Microsoft (MSFT) is scheduled to release its numbers next week. Like most of tech, MSFT has taken its lumps this year, most recently having fallen around 23% from its mid-August highs:

Chart 1: Microsoft (MSFT), 7/27/22–10/20/22. Microsoft (MSFT) price chart. Bounced after two-month, 23% correction.

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

And even though the stock bounced with the rest of the market over the past week or so, MSFT is still down around 30% for the year. Earnings are currently scheduled for next Tuesday.

Compared to most of the big-tech club, MSFT’s earnings-day price moves haven’t been particularly large. Over the past 12 quarters they’ve ranged from +6.7% to -5%, with a five-year average around +/-2.8% (yellow dashed line):

Chart 2: Microsoft (MSFT) earnings-day price history. Avg. earnings move of +/- 2.8%.

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

Nonetheless, earnings season is always full of surprises, which is why some traders use options spreads that can help them act on a specific short-term price forecast and risk level.

For example, a trader expecting a limited rally in a stock could, instead of simply buying an at-the-money (ATM) call, use a vertical (bull) call spread, which pairs the ATM call with a short, higher-strike call—offsetting some of the cost of the long call, but also limiting the position’s potential gains. (Bearish traders could invert the strategy by purchasing an ATM put and selling a lower-strike put.) For traders with focused profit and time horizons, though, this can be a perfectly acceptable compromise.

But the strategy doesn’t necessarily have to sell one option for every long option. A “ratio spread” uses unequal numbers of options to further tweak the position’s risk–reward profile. For example, a trader may choose to buy one ATM call and sell two of the higher-strike calls, which results in the following risk profile:

Chart 3: Call ratio spread: Risk profile. Limited downside risk, unlimited upside risk.

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

Like the basic (1:1) vertical call spread, this 1:2 ratio call spread has limited downside risk—losses are capped no matter how far the stock falls below the long option’s strike price. Similarly, the ratio spread’s maximum profit at expiration occurs if the stock closes at the short-call strike price, in which case both options expire worthless. Unlike the basic spread, though, the ratio spread’s gains diminish if the stock rallies above the upper strike price, and the position is exposed to unlimited losses if the stock continues to rally.

So, why would a trader use the ratio spread? Because it contains two short options instead of one, the ratio spread allows the trader to collect twice as much premium, which makes it cheaper than the basic vertical call spread. Thursday afternoon, for example, a 1:2 MSFT November ratio spread combining a long ATM call and short calls with a strike price roughly 12% above the current stock price was around 17% cheaper than a plain vertical call spread.

Ratio spreads don’t always use the 1:2 ratio shown here. The more short options relative to long options, though, the greater the potential risk. For instance, using a 1:3 ratio (long one ATM call and short three higher-strike calls) would be more aggressive and riskier than using a 1:2 ratio spread, while using a 2:3 ratio would be less risky.

Market Mover Update: More than a hundred additional Campbell Soup (CPB) November $47 puts traded on Thursday—along with 1,000 of the November $50 puts and 1,000 of the November $45 puts (see “Traders open a can of puts”). Knight-Swift Transportation (KNX) fell 7.7% intraday on Thursday after Wednesday afternoon’s earning miss (see “Truckload of options”).

Today’s numbers include (all times ET): Baker-Hughes oil rig count (1 p.m.).

Today’s earnings include: American Express (AXP), Simply Good Foods (SMPL), Verizon (VZ), HCA Healthcare (HCA).


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