As investors, this can be a nervous time to enter the market as any surprises in a company’s earnings can have a drastic impact on its share price. In iInvest Advisory’s experience, trading volumes tend to be thinner, and the market may see increased volatility as traders position themselves ahead of a company’s earnings announcement.

Investors can consider certain strategies to gain exposure to a rising share price while only risking a small amount of capital relative to the amount normally required to fund the share purchase.

One such strategy is a long-call trade. Buying a call option gives the investor time to see how a company’s results have been received by the market before outlaying more funds to purchase the stock. 

If the results are good and the share price has lifted, the investor can simply exercise their options contact and purchase the stock at the pre-set strike price. 

If the results are poor, the investor can sell their options back into the market and avoid the total cost of buying the stock. 

The long call gives the investor time to decide whether to buy the shares after the company reports its earnings and its share price has reacted to the news. 

Below are some key points about how call options work:

1. Understanding the Strategy

• Call Options: These financial derivatives give the buyer the right (but not the obligation) to purchase shares at a predetermined price (the strike price) before a specified date (the expiration date).
  
• Options Premium: The cost to the investor for buying a call option is the options premium. It is typically a fraction of the cost of buying the actual shares.
  
• Contract Size: Typically, each options contract reflects 100 shares in the underlying asset. 
  
• Risk Protection: The options premium is the maximum amount an investor can lose. This may shield them from significant share-price declines resulting from poor earnings announcements.
  

2. Long Call Option Scenario – Fortescue Ltd (ASX: FMG)

[Editor’s note: this worked example is based on assumed figures and is not a recommendation]

• Assume FMG is currently trading at $21.50.
  
• FMG is due to release its result from mid to late August.
• As an investor, you have two choices:

a. Buy 3,000 Shares

• Total cost is $64,500 (excluding brokerage).
• Purchase 3,000 FMG shares at the market price of $21.50
• Exposure to market risk if results disappoint is $64,500.

b. Buy 30 September $21.50 Calls

• Buying 30 contracts of the September $21.50 calls gives you the right to buy 3,000 FMG shares at $21.50 each anytime until 18 September.
• Options premium is $1.00 per contract.
• Total cost is $3000 (excluding brokerage).
• If results are poor and FMG’s share price falls, you decide not to exercise the option, limiting your loss to $3000.
• If results are positive and the share price rises, you exercise the option, locking in the $21.50 purchase price.

3. Trade-Offs

• Upside: The option allows you to delay the decision to buy FMG shares until after the results, reducing market risk.
• Downside: The cost basis for your shares rises to $22.50 due to the $1.00 option premium you have paid.
   

[Editor’s Note: Benefits and Risks of Investing in Options has information on the risks of options strategies, including call options strategies. With call options, the risk to the buyer is limited to the premium paid, if their view on a stock is incorrect. Many factors, including interest rate expectations, economic data, company earnings and market sentiment can affect the direction of a company’s share price in the short term, and thus call options strategies over a stock.]

Sell put options

Another strategy that may be used by professional traders is to sell put options. This acts as a method of either potentially profiting from the premium received or as a strategy to try to purchase a stock at a discount to current market levels. 

Similar to call options, put options give an investor the right (but not the obligation) to sell at a predetermined price (the strike price) before a specified date (the expiration date). When an investor sells a put contract, they effectively agree to purchase shares at the strike price, assuming the counterparty exercises their option. 

In iInvest Advisory’s opinion, an investor might see the share-price volatility that normally occurs around results reporting as a good time to earn increased premiums by selling naked put options. [Editor’s Note: A naked put refers to a put option that is sold by itself (uncovered) without any previously set-aside shares or cash to fulfill the option obligation at expiration.]

While iInvest Advisory believes this strategy is not for everyone (it’s possible to lose the entire amount invested, and sometimes more, depending on the options strategy), it can potentially be effective use when managed correctly.

Let’s look at an example, again using FMG: 

[Editor’s note: this worked example is based on assumed figures and is not a recommendation]

1. Short Put Scenario – Fortescue Ltd (FMG)

• FMG is currently trading at $21.50.
  
• Sell 30 FMG September $20.50 puts at a premium of $1.00.
• Investor receives $3000 in premium (less brokerage).
• This gives the investor the option of purchasing 3000 FMG shares at $20.50 until the September options expiry.
• If FMG shares were to fall below $20.50 at the September expiry, the investor would be expected to purchase the shares at the strike price. 
• The net cost to the investor would be $20.50 per share, less the $1.00 in options premium received ($19.50). 

2. Warning with Selling Puts

• Selling puts carries additional risk. Investors must have enough capital to cover the margin requirements.
  
• Ideally, investors would only sell puts up to the value of stock they are able to purchase. However, there are methods to reduce the additional risk associated with naked put positions. 
  

iInvest Advisory considers that timing option trades is critical and can be challenging. A good stockbroker can assist by providing key dates and other factors to consider. In iInvest Advisory’s view that can significantly impact the results that investors receive. 

Remember, investors should always consider risk tolerance and investment goals, and seek financial advice from an Australian Financial Services Licensee when implementing such options strategies.

DISCLAIMER

This communication is provided for information purposes only and does not constitute financial advice.  Independent advice should be obtained from an Australian financial services licensee before making investment decisions. It is not intended as a recommendation or a solicitation to buy, sell or hold any investment product. This information is general in nature and does not take into account the financial situation, objectives or needs of clients. Any information provided by third parties has been obtained from sources believed to be reliable and accurate. However, iInvest Advisory does not warrant its accuracy and assumes no responsibility for any errors or omissions.