Another earnings season is upon us and with that is an expected increase in volatility. With such big moves coming on earnings reports, how can an investor participate while managing risk? How can you get an edge that's better than the flip of a coin? Bob Lang of explosiveoptions.net likes to use the defined risk that options can provide and he uses a trade in Meta stock to illustrate.
Audio Version Of Podcast
Looking at the 710 call option on Meta stock expiring on Aug. 1, the premium was around $15 as the stock closed at roughly 695. Meaning, Meta stock would have to jump 30 points to 725 before Friday just to break even on the trade. That's 15 points to the strike and then another 15 for the premium.
Lang decided that a $1,500 outlay per contract (15 multiplied by 100 shares) was a little too much for him. So he sold the 735 call to help bring the cost down. Since it was further out of the money, the premium was only $7 but the credit helped offset the cost of the long call. That reduced the cost down to $8 (or $800 when multiplied by 100 shares) per spread (15 from the long call less 7 from the short call). This type of spread is known as a bull call spread.
Sure it costs less but there is an opportunity cost as well. The long call has a bigger ask to become profitable at 30 points, but once you do, the potential gains are unlimited. The more Meta stock goes up, before the Friday expiration, the more money you make on the long call. If you exercise the call option and take possession of the stock, you could let those gains continue beyond the expiration date.
But the bull call spread caps your profit level. The break even price drops down from 725 to 718. But the maximum profit goes from unlimited to a maximum of $1,700 per spread. Taking the 25 points as the width of the spread minus the net premium cost of 8 gets you 17 multiplied by 100 shares. There's no free lunch.
How Meta Stock Earnings Played Out
In its earnings report on Wednesday, Meta beat expectations for both revenue and earnings. Chief Executive Mark Zuckerberg pointed out the efficiency that AI is bringing to Meta's advertising business which provides 98% of their revenue.
The stock soared over 11% to close at 773. If the stock were to finish Friday where it did on Thursday, that would have made the 710 long call option swell from a cost of $1,500 to a value of $6,300 per contract. A 320% gain. However, those gains were halved by Friday's action to "only" a 200% profit with Meta finishing around 750.
The profit on the bull call spread, by contrast, gets capped above the short strike of 735. Even so, at a cost of $800 the value of the spread is the same whether Meta stock finished at Thursday's level of 773 or Friday's level at 750. Either way, achieves the maximum profit of $1,700 and is still a 112% return on risk. Not too shabby for a couple of days.
That kind of return is possible with the leverage of options but Lang warns that leverage can cut both ways. As Friday's action showed, profits can evaporate quickly. Especially with a trade that has little time to expiration, there isn't room for adjustment. Lang also warns that recognizing the leverage of options means that he doesn't try to overdo it by being fully invested. He keeps a healthy amount in cash.
In addition to the Meta stock option trade, Lang also shared on the podcast his overall market thoughts as well as a recent trade in Cadence Design Systems.
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