How does 64.3% of profit sound for a few days of work? Did I get your attention yet? This is a simple case study on how buying a call option before an earnings announcement can help you to earn money. Every thousand dollars invested in this trade would have yielded you $630.
Let’s get started.
You have been monitoring facebook for a while. It seems undervalued and you feel that the analysts are underestimating mobile as a driver of advertising revenue growth. The charts look good and are telling you that entry at this time is good.
You decide that a long call position should be the strategy that you should use to profit from upside moves of facebook stock.
You then do some investigation to find out which call option at what strike price is suitable for the trade. You are extremely bullish on the company and feel that the price is going to shoot up over the next few days.
This is the options chain for facebook and it shows the current month call and put options. At the time of this writing, facebook is trading at $103.31. It is the 2nd of November 2015. An impending earnings announcement is looming.
Source : www.marketwatch.com
You decide that since you want to capture as much profit as possible, you want to buy the cheapest in the money call option you can find on the current month. The cheapest in the money call option for the current month has a strike price of $103 and the bid-ask spread is 4.10 and 4.20 respectively.(Please look at the options chain above on the left column) That means that you can buy a current month options contract with a strike price of $103, at $4.20 and you can sell a same current month contract with the same strike price at a price of $4.10. You place a buy to open limit order and the order is filled. You managed to buy 10 contracts at a total cost of :
4.2 x 100 x 10 = $4200
Now you wait for the announcement to occur and this is what happens next. Facebook gaps up by more than $5 on the 5th of November after a very positive earnings announcement. Analysts now label the stock as “unstoppable”.
Now take a look at the price of your options. The bid-ask spread is now $6.90 and $7.05 respectively. You proceed to place a sell to close limit order and the order is filled at $6.90.
You bought your 10 contracts of call options at $4.2 and liquidated them at $6.9.
Your total cost excluding commission was $4200 as calculated earlier. You sell out and collect : $6.9 x 10 x 100 = $6900
Your profit is: $6900 – $4200 = $2700
Your percentage profit on this trade is 2700/4200 x 100% = 64.3% (rounded off to 1 decimal place)