Let's say I believe that a stock will go up 10%, after the release of earnings. It may take 1 day or 2 weeks. I want to be a call buyer, and not a put seller because I do not want to be short put if the company misses earnings and the stock gaps down. When buying the call, what are the factors that I need to consider? What would be the fair price? If I have 3:1 risk/reward, is that good? I'm reading Hull right now but would like to get some ideas from the pros here. Thanks in advance.
Option prices increase before earnings because of the possibility of a big move after earnings. It's very possible that you're right about the stock, it does go up 10%, but the options are worth less because of the decrease in implied volatility for the options. The nearer to expiration the options are, the more this is a factor.
Volatility is certainly a big component, but how do we determine the fair price and which strike gives the most return for the risk.
It depends on what you mean by "fair". Options are priced based on implied volatility. This is the market's prediction of the underlying's volatility in the near future. The IV of the front month options usually increases right before earnings so if you're a buyer of these options you're paying a premium for them. Effectively you're saying "I think the stock will move more than the market thinks it will". So if you believe the stock will move 10% and the IV reflects a smaller predicted move then you're getting a good deal on the option prices. You'd be surprised how frequently the market is correct in its prediction of a stock's near term move. Betting against the crowd is usually a losing game. Straddle traders generally don't use front month options for this reason and instead buy longer expiry options. Their prices are not as affected by earnings IV changes as front month.
The options market is very efficient at pricing in the expected move from earnings into option premiums; there is no "easy money" to be had. As Steve noted, essentially you have to decide that, for whatever reason, you think the move will be bigger (or smaller) than expected by the market and then buy (sell) options accordingly. As you analyze your potential trade, be sure to take into account the vol collapse after earnings, and realize that front-month OTM options can easily go to zero due to that. I am a relatively new options trader, and trade earnings quite a bit, but have been burned enough to realize how exceedingly difficult it is to consistently generate profits from playing earnings (long or short). From what I understand a lot of seasoned traders avoid it.
The best thing to do might be to wait until after earnings and try to find a good entry point if it looks like the stock is going to be making a sustained move for several days.
Ya know, this is kind of old-fashioned but if a company has a strong move due to earnings and it's actually a good company it will probably continue to go up after that. Putting on positions *after* earnings in such a company can be profitable. Again, being old-fashioned, try reading the earnings report after the big move. How did they really perform WRT earnings, earnings growth, revenue? Did they guide higher? That's a sign of future health too.