Playing earnings with backspread

Vertical would be better, with one leg in the money even. You're looking for lower vega because there IS an implied vol collapse after the report (on average).

Backspreads will consistently take losses from that ivol collapse. You will have to be really good picking the ones that are going to move and get direction right... I've never met anyone who could do that consistently. (And I do have a friend who pretty much focuses on playing earnings announcements in widely followed stocks.)

 

Yeah, stop calculating return on debit.

 

I suggest you use extensively google search, options tools, options literature ...

e.g. http://www.optionsplaybook.com/option-strategies/call-backspread/

 

Thank you everyone for your valuable input. I’m completely aware of the fact that there is no free lunch, Holy Grail or strategy that fits all cases.

Yes, it is a directional speculative bet and should be made with only small portion of the portfolio. I’m aware that it will probably lose more times than win. But if I’m right big time, the profits can cover many losing trades.

The goal is to maximize the profits if I’m right and reduce the risk if I’m wrong. Since it usually requires very small debit and in some cases can even be done for credit, the capital required and the risk are much smaller compared to bull spread or straight call. In fact if you get a credit, you can make money even if the underlying tanks.

I agree that calculating profit percentage on debit is misleading, especially since the debit can be very small. However, since it is usually a one day trade, calculating profits on margin is also not the correct way. Theoretically, the maximum loss is the margin, but it is extremely unlikely. So let’s calculate profits as dollar amount per spread.

Using this method, let’s take the PCLN trade and compare the risk/reward of backspread and bull spread with the same strikes (240/250).

The initial capital was about $170-175 for backspread and $250 for the bull spread. In both cases, the breakeven was around 4-5% move in PCLN. In case of 10% move both would make around $300. If PCLN didn't move at all, the backspread would have incurred almost full loss of the debit, the vertical would have only lost about 60%, but in dollar terms, the loss would be almost the same. Now, the big advantage of the backspread: if I’m correct and there is a huge short squeeze, the backspread has unlimited upside compared to the bull spread.

 

No argument there. As mentioned, in the OP's narrow context, a backspread is apt to be a better choice than a long call. But in the real world, also agreed that consistent timing and direction is unlikely. My two cents for these high flying EA's is that the sale of near month high vol against 2nd month is a better choice - something that doesn't lose much in the middle but does well with a pronounced move in either direction.

 

I don't know what the bean counters say the convention should be but for an overnight play, the risk is a lot closer to the debit cost (from your example) than the maximum loss.

The overnight risk is dependent on the amount of IV collapse. If it's small, it will tend to be less thatn the debit cost. If large, it will be a bit more than it but nowhere near the margin risk (expiration).

 

Since the price of option is so expensive, you are selling short to lessen the cost in order to afford it and lessen the risk. I think the risk/reward is the same if you just buy the call. For example, I'd rather buy 1 call option instead of 2 if I think it's too costly instead of buying a back ratio since commission fee is higher.