An Options Strategy You Can Use Before An Earnings Announcement

| April 3, 2012 | 0 Comments

KMX OptionsThere are many ways option traders make money.

Basically, there’s over 50 different option strategies and combinations of strategies that an experienced trader can use.

Obviously, these strategies all depend on how a particular company’s stock is expected to perform at any given time.

Option traders love earnings time.

Earnings announcements give a trader the ability to buy or sell high priced options.

You see, as earnings time gets closer, option volatility increases.  The result, option prices increase as well.

And this allows investors to take advantage of large or small moves in a company’s stock price.

Let me give you a real-life example on a company that’s about to announce earnings– CarMax (KMX). 

This company reports on Thursday after the bell.

One strategy many options traders will be using is known as a short call spread or (bear call spread).

But first, a little about the company…

CarMax is the largest US retailer of used cars.  As of mid-March 2012, CarMax owned and operated 108 used car superstores. It also sells new vehicles at five locations under franchise agreements with four new car manufacturers.

The company also provides financial services to customers through CarMax Auto Finance (CAF).

Now, although the automotive industry is showing some signs of recovery, I think CarMax has a tough road ahead.

Here are a few reasons why…

First, CarMax operates in a cyclical industry.  Meaning, during certain times of the year, CarMax sells more cars than other times of the year.

And given how KMX operates, it’s weaker than the big brand dealers.  It’s not as immune to a possible fallback into economic recession.

Also, CarMax’s recent generous discounting of new vehicles is hurting them.

Although they’re the largest retailer of used cars, this discounting of new cars forces them to compete with the large auto companies.  And it’s hurting CarMax’s demand for used cars.

So, with CarMax’s earnings announcement this week… how are option traders playing this stock?

Over the last few weeks, we’ve seen heavy call buying in the April $34 calls.  This would normally indicate traders believe the stock will increase in value.

However, with CarMax bumping up against a two year high of $36, the way that traders are taking advantage of this earnings cycle is through the short call spread.

You see, by selling the April $34 calls, which everyone is rushing to buy for a whopping $1.80 and then buying the April $36 calls for about $0.80, traders are limiting their risk.

Simply, they’re selling the April $34-$36 call spread for about a buck. So the traders are willing to risk a dollar to make a dollar.

Here’s why this is so attractive.

As KMX stock is bumping against its $34 resistance, this trade will make a little bit of money if the stock goes up and a little money if the stock moves sideways.

And traders will make a dollar (which is the max gain) if the stock goes down and stays below $34 by April expiration.

Bottom line…

Option traders, as well as myself, love to sell options.   What’s more, selling option spreads in front of earnings can be very profitable.  And this one sets up really well.

Safe trading,

Marcus Haber

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Category: Options Trading Strategy

About the Author ()

Marcus Haber is the co-editor of Options Trading Research and boasts well over a decade of real-life options experience. Learning from some of the biggest names in the business, Marcus has served as an Options Strategist for a number of firms and was also appointed to the Options Advsiory Board with Pershing, a branch of the Bank of New York.