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Lesson 4 Earnings Probability Spread

This document provides an overview and instructions for using an earnings probability spread options trading strategy. The strategy involves opening a 3-legged spread position around an upcoming company earnings announcement in order to profit from an expected move in the stock price while limiting risk. Key aspects of the strategy covered include choosing optimal stocks, determining strike prices, calculating profit/loss potential, and guidelines for entering and exiting the trade around the earnings date. Pros and cons are discussed, such as limited risk but good risk/reward ratio and low capital requirement.

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377 views

Lesson 4 Earnings Probability Spread

This document provides an overview and instructions for using an earnings probability spread options trading strategy. The strategy involves opening a 3-legged spread position around an upcoming company earnings announcement in order to profit from an expected move in the stock price while limiting risk. Key aspects of the strategy covered include choosing optimal stocks, determining strike prices, calculating profit/loss potential, and guidelines for entering and exiting the trade around the earnings date. Pros and cons are discussed, such as limited risk but good risk/reward ratio and low capital requirement.

Uploaded by

vvpvarun
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Professional Advanced

Options Trading Course


Lesson 4: Earnings Probability Spread

Adam Khoo Bang Pham Van


Professional Trader Options Trader & Specialist

www.piranhaprofits.com
www.wealthacademyglobal.com
Earnings Probability Spread

High Rewards for Very Low Risk
• Speculating on a price increase when a company announces better-than expected
earnings is a common strategy.
• The risk is that if the price gaps down because of a bad result, the trader can stand
to lose big as well
• Buying the stock and places a stop loss will not prevent a ‘bigger than expected’ loss
• Buying a Straight Call Option can be ’Expensive’ with High Volatility before Earnings
• We need a Call Spread Strategy with Low Risk and Very High Returns!

$130
+4% $219
$125

-13%

$190

Earnings Earnings
Release Release
Earnings Probability Spread

The Strategy!… 3 Legs
1) Leg 1: Buy 1 ATM Call (Delta 50+)
2) Leg 2: Sell 3 OTM Calls at a Strike Price where you think the price will
increase to. This could be 2 or more strikes higher
3) Leg 3: Buy 2 further OTM Calls at a strike distance that is
half the strike distance between the first 2 legs

$129 Buy 2 MSFT 131 Call


Sell 3 MSFT 129 Call
Current Price $125 Buy 1 MSFT 125 Call

Buy 1 MSFT 125 Call Lower strike


4 strike diff
Middle strike
Sell 3 MSFT 129 Call
2 strike diff
Buy 2 MSFT 131 Call Upper strike
Earnings Probability Spread

The Strategy!… 3 Legs
1) Leg 1: Buy 1 ATM Call (Delta 50+)
2) Leg 2: Sell 3 OTM Calls at a Strike Price where you think the price will
increase to. This could be 2 or more strikes higher
3) Leg 3: Buy 2 further OTM Calls at a strike distance that is
half the strike distance between the first 2 legs

$187.5 Buy 2 FB 190 Call


Sell 3 FB 187.5 Call
Current Price $182.5 Buy 1 FB 182.5 Call

Buy 1 FB 182.5 Call Lower strike


2 strike diff
Sell 3 FB 187.5 Call Middle strike
1 strike diff Buy 2 FB 190 Call Upper strike
Earnings Probability Spread

PFE is trading at $39.48 on 25th April
Earnings will be announced On 30th
April and you expect the price to
move to $40.50 ($1.02 increase)

Buy 2 May 41.00 Call -$0.36


1 Strike
Sell 3 May 40.50 Call +$0.945
2 Strikes
Buy 1 May 39.50 Call -$0.72

-$0.14

ATM Buy 1 Call


Sell 3 Calls
Buy 2 Calls
Earnings Probability Spread


Max Profit $86+


Profit/Loss at Expiration

Profit $30
Profit/Loss before Expiration

$39.64 $40.93

Max loss $14 $40.50 Max loss $14


$39.32 $41.35
Middle
Strike

Max Loss = Net Debit = $0.14 x 100 = $14


Earnings Probability Spread

Buy 2 OTM Call Higher Strike
The Strategy
• 3 legged strategy, involving 6 call options ’1/2 N’ Strike difference
• Buy 1 ATM Call , Sell 3 Higher Strike Calls, Sell 3 OTM Call Middle Strike
Buy 2 Even Higher Strike Calls (1, 3, 2)
• All Calls expire on same date (within 5 days
’N’ Strike difference
of Earnings release)
Buy 1 ATM Call Lower Strike

Maximum Loss
Max Loss (Capital Required) = Net Premium Debit

Max Profit = Middle Strike - Lower Strike - Net Premium Debit

Breakeven at Expiration
Lower Breakeven Point = Lower strike + premium
Higher Breakeven Point = Highest strike - 1/2 premium

7
Earnings Probability Spread

Profit Buy 2 OTM Call 41.00 Higher Strike
1 strike
Sell 3 OTM Call 40.50 Middle Strike
+$86.00
Max profit = 2 strike
middle strike -lower strike - Net Premium Debit
Buy 1 ATM Call 39.50 Lower Strike

Net Debit = $0.14

Stock Price
$40.50
-$14 -$14
Lower Middle Higher
Max Loss =
Net Premium Debit Breakeven Strike Breakeven
39.64 40.93
Loss Lower Breakeven Point = Lower strike + premium
Higher Breakeven Point = Highest strike - 1/2 premium
Optimal Entry and Exit Rules
Optimal Entry Rules
• Find an S&P 500 stock with a high probability of beating earnings forecast (zacks.com
Earnings Calendar -> Earnings Surprise Predictor Positive )
• Enter the trade within 1-5 days before the earnings event
• Ensure Expiration Date is just after the earnings event (within 1-5 days)
• Choose the middle-strike (sell 3 OTM Call) where you project the price will gap up to
• Risk versus reward ratio of 1: 5 (or higher) is ideal

Optimal Exit Rules


• Close the trade once you can reach 30% to 50% of Max Profit
• Scenario 1: Stock Price below Lower Strike after earnings
• Let the options expire worthless for a loss
• or.. close the trade if remaining value > closing cost
• Scenario 2: Stock price is between Lower & Higher Strike
• Close the trade just before expiration for a profit
• Profit is highest just before it expires (4pm Eastern Standard Time)
• Scenario 3: Stock price is above Higher Strike
• Close the trade before expiration to avoid exercise fees
• An early exit could still result in a breakeven or even a small profit

Note: Long Call that are ITM will be exercised automatically


and Short Calls ITM will be assigned !
Step to Open Earnings Spread
Best to trade this strategy during earnings season Starting March, June, September December

• Step 1: Got to zacks.com -> Earnings Calendar. Look at stocks announcing earnings over the next
1-2 weeks
• Step 2: Shortlist stocks with the following attributes
• a) Price above $30 from the S&P 500 Index. High Relative strength preferred
• b) Zacks Earnings Surprise Predictor Positive. Ranked ‘Hold’ or above
• c) Options that expire within 5 days after earnings announcement
• d) Check how much price increased during previous earnings announcements. Also
check the projected price increase on the option chain upon expiration
• Step 3: Go to the Call Option Chain
• Buy 1 ATM Call (Expiry just after earnings), Sell 3 OTM Calls ’N' strikes higher, Buy 2 OTM Calls
another ‘1/2N strikes higher (1, 3, 2)
• Step 4: Click ‘Analyze Trade’
• Analyse the Profit and Loss Chart to check maximum loss, maximum profit and breakeven
prices
• A risk/reward of at least 1: 5 is ideal
• Step 5: Choose the Number of Contracts
• Choose number of contracts in multiples of 1,3,2 (e.g. 2,6,4 OR e.g. 10, 30, 20)
• Total Net Premium Debit should be 1% to 2% of Your Net Liquidation Value
• Step 6: Check the Total Net Premium Debit, Click ‘Confirm and Send’ as a Limit Order
• Step 7: Check the Order Confirmation
• Max Loss, Max Profit, Buying Power Effect
• Step 8: Go to Monitor -> Activity & Positions -> Check Trade Status
Other Considerations
•To increase the Risk/reward ratio, narrow the strike
differences – keep the same short strike, but move the two
long strikes closer (with the same distance ratio)

•This strategy can be used with put options to bet on bearish


outcome of earnings
Pros & Cons – Earnings Spread
• Pro’s:
- Limited risk
- Very good Risk Reward ratio
- Low capital requirement
- Short Vega. Trade Benefits from Implied Volatility crush post
earnings
• Con’s:
- Maximum Profit is Capped
- Most of the profit is realised just before expiration
- Commission intensive due to 6 options used
Professional Advanced
Options Trading Course
Lesson 4: Earnings Probability Spread

Adam Khoo Bang Pham Van


Professional Trader Options Trader & Specialist

www.piranhaprofits.com
www.wealthacademyglobal.com

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