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9 Weeks to Better Options Trading: Special Situations: Earnings Reports, Takeovers, and Extreme Market Moves

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Veteran options trader Steve Smith breaks down special situations.

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This means that all else being equal, the May $19 calls, currently trading around $0.80, will lose about $0.15, or 18% of their value after the report. That likely decline in implied volatility means the purchaser of calls has a major headwind to overcome. To help mitigate this "post earnings premium crush" (PEPC), one could consider selling the $21 calls for around $0.30 to create a $19/$21 vertical spread. Again, no matter what happens, those $21 calls sold against the $19s will also suffer a PEPC, helping offset the implied volatility value lost in the long calls.

Extreme Moves

These occur when a company warns of a profit shortfall and or raises guidance before the official earnings release, a sudden change in management, or other unscheduled news events such as lawsuits or accounting issues. I generally stay away from issues of lawsuits and accounting as they fall under the "cockroach theory" -- that is, there are usually more of those bad buggers around than first appear. In most cases, the best move is no move.

Fading the News

However, on warnings and shortfalls, I will usually take a "fade" approach. That is, if a stock gets whacked on an earnings warning, I might sell some put spreads to set up a moderately bullish position. When big news hits, the first move is usually an overreaction, and implied volatility will initially jump dramatically. Subsequently, one can expect both price and implied volatility to stabilize once the news is digested.
No positions in stocks mentioned.

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