To the naive spectator earnings announcements may seem like manna from heaven – a godsend providing instant outsized profits. It’s not uncommon to see stocks explode higher capturing huge gains in a single day following their quarterly release. Take Google Inc. (GOOG) for instance. In response to its last two earnings releases it was up a quick 13% and 7%, respectively.
Unbeknownst to these shortsighted investors is the fact that a large portion of the so-called manna is laced with arsenic. Many earnings announcements are downright toxic and can result in instant losses of epic proportions. Just ask any Netflix junkie that held into the October 2011 announcement which resulted in a 37% gap down.
Over time as earnings seasons come and go, one overriding truth becomes apparent – earnings announcements are the playground for degenerate gamblers.
Fortunately, shareholders can sidestep the earnings drama by utilizing the risk-reducing nature of the options market. The iron-clad collar strategy affords the ability to protect stock positions into earnings. To initiate a collar, stock owners sell an out-of-the-money call option while simultaneously buying an out-of-the-money put option in the same expiration month. With the collar in place, traders enter earnings with defined risk to the downside and limited reward to the upside.
Since Goldman Sachs is slated to report earnings next Wed January 18th, we’ll use it as an example. Though, admittedly, it doesn’t tend to be a huge mover on earnings.
Suppose you own 100 shares of Goldman Sachs (GS) which is currently trading for $98.50. To enter a collar you could sell the February 100 call for $4.15 and buy the Feb 95 put for $3.35. At current prices you would receive a credit of $.80 to initiate the collar (the risk graph below displays the collar position).
By purchasing the Feb 95 put you acquire the right to sell your shares at $95. That limits your downside risk to $3.50 (98.50 – 95) minus the $.80 received from entering the collar, or $2.70.
By selling the Feb 100 call you obligate yourself to sell the stock at $100. That limits your profit potential to $1.50 (100 – 98.50) plus the $.80 received from entering the collar, for a total of $2.30.
Next time your waffling with whether or not to hold a stock position into earnings, consider appealing to the protection afforded by the collar.