Combat Your Earnings Fears with Collars

by Tyler Craig on January 13, 2012

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.

Source:  MachTrader

{ 4 comments… read them below or add one }

MarkWolfinger January 13, 2012 at 2:10 pm

Limiting the upside gain to a measly $1.50 by collecting 80 cents for the call option is not for me. For $80 total. I’d settle for owning the put option.

Reply

Tyler Craig January 14, 2012 at 8:08 am

Hey Mark,

We’re collecting $4.15 from the sale of the 100 call which is $.80 more than what was paid for the 95 put ($3.35). So the $.80 is the net credit for the collar, not just the short call.

The upside gain, then is $1.50 + $.80 or $2.30.

In the event we only received $.80 from the short call, we’d be in agreement. It wouldn’t be worth it.

Reply

heywally January 15, 2012 at 6:12 pm

“Over time as earnings seasons come and go, one overriding truth becomes apparent – earnings announcements are the playground for degenerate gamblers.”

Thanks for the options perspective …. the above is true to a large extent but it’s also true that you can pick out a few stocks in the post market after the reports, with great earnings and guidance, buy a conservative amount, and ‘usually’ flip them for a nice profit in the next day’s pre-market or at the open, assuming you’ve got the context right and the overall market isn’t horrendous. That is gambling too.

Reply

Kirk Nathaniel January 17, 2012 at 3:04 am

You gotta also think that even with your Google earnings example there have been times where Google has had strong earnings and yet gapped much lower since they weren’t good enough. I think the downside protection is much more important but hey, if you can keep some upside potential thats great too.

Reply

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