Corporate events are a major driver of stock price volatility. When a company announces earnings, business partnerships, accounting restatements or other significant news, there is often significant stock price movements.
This will often be characterized by a sudden spike in volatility. Whilst traders can use the company’s stock to trade on such corporate events, options are often the preferred trading instrument as they can be combined to express more complex views on short term historical stock price movements.
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Understanding Corporate Events
Before examining options trading strategies, it is important to have a clear understanding of the different corporate events and how they can impact stock prices:
Earnings Reports: Typically the most common corporate events are the regular release of quarterly or annual earnings reports. Volatility typically spikes immediately after an earnings release, and hence options are most expensive prior to a release.
Mergers and Acquisitions (M&A): When two companies merge or one company acquires another, it can impact the stock prices of both entities. Typically the stock of the acquirer is neutral to slightly lower and the acquisition target stock rallies. Investors usually trade M&A by anticipating the acquisition and purchasing the potential target’s stock in advance, or creating a ‘spread trade’ by entering a short position for the acquirer and a long position for the target.
Dividend Announcements: Companies may announce changes in their dividend policies, such as increases, decreases, or suspensions. Usually the stoick price will only move on a dividend cut or suspension.
Options Trading Strategies for Corporate Events
Straddle: A straddle is the purchase of a call option and put option at the same strike price and expiration date. Traders use this strategy when they expect a significant price movement but are unsure of the direction. For example, if a trader anticipates an earnings surprise but is unsure the direction of the move.
Strangle: Similar to a straddle, a strangle involves buying both a call and a put option, but with different strike prices. This strategy is suitable when the trader anticipates a significant move but is uncertain about the direction. It is less expensive than a straddle but requires a larger price movement to be profitable.
Bull Call Spread: In this strategy, a trader buys a call option and simultaneously sells a call option with a higher strike price. It’s used when the trader expects a moderate bullish move in the stock’s price.
Bear Put Spread: This strategy involves buying a put option and selling a put option with a lower strike price. It’s employed when the trader anticipates a moderate bearish move.
Iron Conder: This is a neutral options strategy that combines a bull put spread and a bear call spread. It’s useful when a trader expects low volatility after a corporate event.
Probably the biggest issue with trading options around corporate event is the option price being conditional on the prevailing volatility. Thus during longer periods of high volatility, trading using options can become uneconomic due to the high cost on creating the options positions.
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