Corporate events often have a large impact on stock prices, whilst traders can use each company’s stock to trade these events, several unique properties of options are ideally suited to trading these scenarios.
There are several primary categories of corporate events:
These are regularly scheduled events and so the timing can be anticipated, however, the trader may wish to either profit from an unanticipated change in earnings or protect an existing portfolio position.
For example, if a trader believes that a company that has a stock trading at $105 will report an earnings surprise they can purchase a short-dated call option with a strike price of $100 and simultaneously sell another call option with a higher strike price (eg $110). This options combination (ie an option strangle) is much cheaper to purchase than an outright call option or a simple long stock position. This will allow the trader to benefit from an increase of stock price up to $110, thereafter the trader forfeits any gains.
It is important in back-testing this strategy to use a historical options data source such as FirstRateData options.
Traders can use option straddles or strangles to profit from the volatility surrounding earnings announcements. An option straddle is similar to the above strangle, but the call and put options have the same strike price. Both strategies are effective when traders expect a significant price move but are unsure of the direction.
Mergers and Acquisitions (M&A)
Traders typically use call spreads to profit from expected stock price increases in M&A deals. For example, a trader who believes that the target company in an M&A deal will see its stock price increase can buy an out-of-the-money call option on the target company's stock and simultaneously sell a call option at a higher strike price.
The call spread is a bullish strategy in that the trader will not profit unless the stock price increases. The short leg of the trade (ie the sale of the high strike price option) is usually necessary as the long-only call trade would likely be too expensive versus the potential payoff.
Dividend announcements are similar to the M&A trades above, except that dividend announcements are almost always bearish (very few stocks will rally significantly on a dividend hike whereas a dividend cut usually leads to a large selloff). Thus, a trader will usually use a ‘put spread’ to position for a dividend announcement. The put spread is similar to the above call spread except it is made using put options purchased a strike prices below the current stock price.
For example, for a stock trading a $100, the trader would purchase a put option at $90 and sell a put option at $80. Thus the trader will profit from stock price falls up to $80.
Both the M&A and dividend announcement trades are made using long-dated options with expiries over 1 month and so can be too expensive during periods of high volatility when long-dated option prices are elevated.
Using options to trade corporate events is much more complex than long-only stock positions and so the trader needs to monitor several issues:
Margins: Options trading is a leveraged strategy, so typically an initial margin will be posted and this needs to be maintained over time so the trader will be required to make further investments if the trade is losing money. This contrasts with the long-only stock position in which the full investment is upfront with no additional investment required.
Liquidity: It is important to trade options contracts that are liquid. Illiquid options can have very bid-ask spreads and make a winning trade unprofitable simply due to the execution costs of entering and exiting the trade. Thus the trader will need to carefully monitor the bid/ask spread for all options used in the strategies.