We know death and taxes are the only sure things, right? Now you can add implied volatility spikes during earnings season to that list. Option prices traditionally increase as the earnings date approaches with more and more uncertainty arising about the data. More often than not, implied volatility in the front month options trades considerably higher than that of the next corresponding expiration months. Many option traders employ spreading strategies that look to take advantage of this difference amongst expiration months. Some of these strategies include: calendars, diagonals, and straddle/strangle swaps. Each of these strategies incorporate time spreads for short gamma trades that make their money through time decay. These strategies also provide the opportunity for more time decay collection over multiple expiration months if rolls are implemented. I tend to implement these time spreads during earnings plays when I don't have a directional bias on the stock and I assume that the stock will remain range-bound.

What happens when you do have a directional bias on the stock going into earnings? Should you just buy a call or buy the stock, or a combination of the two? Remember, you are trying to take advantage of the fact that the increase in implied volatility provides excellent opportunities for increased time decay collection. If you are currently slightly bullish on any stock heading into its earnings date, you could consider call ratio spreads as a possible trade. If slightly bearish, then put ratio spreads might be more effective.

Let's take a look at an example in YHOO. The company had announced earnings for January 27, 2009. With a day to go before the release, the February 10 calls were trading for $1.80 and the February 13 calls are trading for $0.47. If I were very bullish on the stock, I might consider solely purchasing the February 10 calls for $1.80. However, with the stock trading at $11.22, I am not willing to pay the $0.58 in extrinsic value, or time value, heading into earnings. Remember, as I stated above, the implied volatility spikes right before the earnings date, so we want to take advantage of that spike. If we consider selling two of the February 13 calls to finance our purchase of the one February 10 call, then we are eliminating most of the time decay concern from our trade and our new cost for the slightly bullish trade becomes approximately $0.86 instead of $1.80. Look at how the trade is constructed down below:

This trade is a non-defined risk trade. If YHOO is to rally to $15.14 before February expiration, then we will be short one naked call from our ratio spread that is not covered by our long position in the February 10 call. This naked call could represent unlimited risk to the upside. However, in terms of probability, we are assuming about a 9% probability of YHOO settling above $15.00 at February expiration. This is why I stated above that this trade is assuming a slightly bullish bias. We have two break even points on the trade. The first is at $10.86 which is our long strike plus the $0.86 debit that we paid for the trade. The other break even point occurs at $15.14. Thus, we have a possible range of $4.28 of profitability on a stock that trades $11.22. I like those odds. Instead of owning the stock, we are using spikes in implied volatility to finance our long call purchase by way of the ratio spread. The maximum value of this spread occurs at our short strike, or the $13.00 level. If we construct only one of these ratio spreads, then our $89.00 debit could be worth over $200 if YHOO settles at $13.00 on expiration day. My biggest concern for this trade would be an announcement of another deal with GOOG or MSFT before February expiration. Then, we might have to be concerned about our upside risk, as our position becomes a naked short call after the $15.14 price level.

Good luck and happy trading!

thinkorswim, Inc. and its registered employee, Joe Mazzola, do not solicit or recommend any form of trading in the individual stocks (or their derivatives) mentioned above. Please do careful, independent research before investing any money as well as weigh the possible consequences on your particular financial situation before doing so. The risk of loss may be substantial.