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Options for Earnings Plays

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Know the expectations.

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MINYANVILLE ORIGINAL The wave of quarterly earnings reports is beginning to wash across traders' screens and it won't crest for another week. For some active traders, these jolts of information and the accompanying stock price movement represent terrific short-term money-making opportunities. And many will try to juice the returns by using options.

Before getting to some of the concepts and strategies that can be employed in playing earnings reports, let me provide the caveat: All earnings plays are extremely speculative and should only involve a minimal allocation of risk capital. The challenge in trading earnings is that there are many variables that need to be accounted for and correctly forecast.

Not only must you determine if the company will meet estimates (and whether those estimates recently been lowered or raised) and what kind of guidance will be provided, but you also must determine what has already been priced into the stock, and whether it has recently run up or sold off. And most importantly for our purposes, you must determine what percentage price move the options are pricing in as measured by their implied volatility (IV).

For example, look at UnitedHealth Group (NYSE:UNH) this morning. Despite delivering better-than-expected results and a mostly positive outlook, shares are off some 2% at the opening. Is this sell-off simply a pullback after a nice run in which UnitedHealth had rallied some 12% since being added to the S&P 500 Index (INDEXSP:.INX) one month ago -- or is it a sign that investors are truly concerned? Will Google (NASDAQ:GOOG) -- whose stock has run up approximately 27% during the past six weeks -- suffer a similar sell-the-news reaction following its earnings report this Thursday?

Imagine the game of "what is baked into" Apple's (NASDAQ:AAPL) earnings next week with the ingredients including its recent 10% sell-off, the speculation surrounding the iPad mini release, and iPhone 5 sales. I expect the implied volatility for Apple options, which have already increased by 25% to 38% over the past two weeks, to be near 52- week highs, and near 43% by the time it reports next Thursday. And then -- no matter what the results or response -- expect implied volatility to decline back towards the mid-30s level.

Prepare for Post-Earnings Premium Crush

The tendency for a post-earnings premium crush (PEPC) to occur makes understanding the relative "expensiveness" of options and the magnitude of the price move being priced in crucial to improving the probability of achieving a profitable trade.
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No positions in stocks mentioned.

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