A less risky way to bet on a chip stock with a reasonable valuation ahead of earnings

Published Mon, Nov 20 202310:52 AM EST

Before I preview the big events ahead this week and some attractive set-ups into earnings, I want to do a basic review of how options traders go about event-driven trading. Event-driven trading is a strategy used by traders to speculate on price movements resulting from significant events. This type of trading is based on the expectation that events such as earnings reports, mergers and acquisitions, regulatory changes, or other significant news can lead to a security, such as a stock or bond, or other speculative underlying such as a commodity price or interest rates, to move more sharply than usual, thus creating a trading opportunity… assuming one guesses on the direction correctly. The first step is to identify upcoming events where new information will be available to traders and investors of significant importance. These events could be company-specific, like earnings announcements, shareholder meetings, and presentations, or market-wide, such as macroeconomic data releases. While other events can move prices dramatically, such as leadership changes, regulatory changes, and legal action among many others, for the fund specifically, we focus on scheduled events that are anticipated by most investors and whose timing is well known, for a key reason. An important part of our process is options market sentiment analysis . For our event-driven, long-only investment fund at Optimize Advisors we measure options sentiment quantitively. I've included that score related to our proprietary options market analysis in the table below. (Names highlighted in green are names that we hold in our event-driven fund.) Options market sentiment analysis is a technique used to gauge investors' expectations and attitudes toward a particular stock or the market as a whole, based on options trading data. This analysis is especially valuable because options are financial instruments that give traders the ability to speculate on specific price moves within specific time frames. Because the way traders use options provides insights into their expectations about the direction, magnitude, and timing of future price movements, we can think about changes in those prices the way we think about changes in odds and point spreads on sporting events. Analog Devices The higher the sentiment score, the better we like the stock going into earnings. Assuming Analog Devices (ADI) can achieve the greater than $10 earnings per shares, and substantial free cash flow projection of $4 billion annualized, it is trading at a reasonable multiple. Notice the 4% implied earnings move is not that high, suggesting the risk of a sharp move is low, at least as far as the options market is concerned. That said the stock has rallied sharply off the recent lows and using a call spread might be favorable given the relatively low options premiums here as an alternative to a long-stock position. ADI debit call spread: Bought Dec. $185 call for $4.80 Sold Dec. $195 call for 1.50 Net debit = $3.30 When using a debit call spread, such as the ADI structure illustrated above, one needs the stock to rise above the strike price of the long call by expiration by the amount of premium spent. In this case above 185 + 3.30 = $188.30. The downside of this is that the probability of profit is less than 50/50. The benefit is that one is risking $3.30 in total, or about 1.8% of the current stock price. This brings up an important point. I encourage traders and investors, particularly those new to options, to size their trades the way they would take a position in the underlying stock in terms of risk. Start small. Deere trade There are ways to improve the probability of a long call spread by incorporating a short-put option, as I illustrate in this example in Deere & Co (DE) . Deere trade: Bought Dec. $390 call for $11.00 Sold Dec. $415 call for $3.70 Sold Dec. $370 put for $7.30 In this example, the premium spent on the long $390/$415 call spread is offset by the premium collected by selling the $370 put. Notice that the strikes I've chosen here are guided in part by the recent highs and lows experienced by DE shares (the September high was $417 or thereabouts). DE YTD mountain Deere, YTD Here the tradeoff is downside risk. By selling a $370 put, the option trader may be compelled to purchase the shares at that price should it decline below the put strike by December expiration. The good news that's a discount to the current price. The bad news is each put contract represents 100 shares of DE, so the trader would be purchasing $37,000 worth at that level. To put this risk/reward into context consider two outcomes, one where DE rallies 10% and one where it declines 10% after earnings. In the event that it rallies 10% by December expiration to $422 the trader's call spread would be worth $25/contract x 100 shares per contract = $2,500 profit. On the other hand if DE falls by 10% to $345.74, the short put would be worth $24.27. Multiplying that by 100 shares per contract, the trader in this example would see losses of $2,427, slightly less than the upside gain. So far so good, but the problem here is that the gains are capped whereas the downside losses could be greater if the magnitude of the move is larger. These types of tradeoffs are important considerations when devising an options strategy. Once again this illustration reinforces judicious risk analysis and appropriate trade sizing. As one trades options more often one's intuition and understanding of the risk/reward relationship will improve. DISCLOSURES: (Long NVDA, HPQ, DE) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . 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