You observe that a stock has been attracting market interest in recent times, as the company is expected to announce its earnings sometime soon. You want to bet on the stock moving up but do not intend to keep the position till the company reports its earnings. What should you do? This week, we discuss why buying calls in such situations may be optimal.

Betting on earnings

Consider the characteristics of the intended trade. You are likely to trade near-month equity options having sufficient time to expiry. Hence, time decay (loss in option price due to passage of time) may not be a major cause for concern, though it will still work against the long position. This is because you expect the underlying to move up and intend to hold the position for not more than five-seven days. You observe that the option’s implied volatility is below its recent levels. This gives some room to capture gains from the likely increase in implied volatility. Your position must, therefore, be vega-positive.

Now, long call is optimal compared to a call spread. Why? If you set up a call spread, you will reduce your cost of setting up the trade, but your position will carry lower positive vega. This is because the spread will contain a higher strike short call, and short calls have negative vega. True, the net theta of the spread will be lower than the theta of a long call position. But you must be willing to assume a higher theta to capture likely gains from a higher vega and a larger delta.

Note that you are betting on the call option moving up in price in line with the underlying. That means you are betting on the call delta moving up, boosted by the option’s gamma. Note that the gamma accelerates the call delta when the underlying moves up and reduces the delta when the underlying declines. The above discussion shows that your position must benefit from positive vega, delta and gamma. Hence, a long call position.

The choice of strike depends on the cheapness of the option if you are trading American options and on liquidity if you are trading European options. Note that an option is considered cheap or rich based on its implied volatility. The liquidity of an option is based on the change in open interest for a strike. Considering the various characteristics of the intended position, an option that is one strike higher than the current underlying price is likely to be optimal.

Strike matters
The choice of strike depends on the cheapness of the option if you are trading American options and on liquidity if you are trading European options

Optional Reading

The chosen strike will carry a delta close to 0.50. As an at-the-money (ATM) or near-ATM strike, this option will have high vega and gamma and, therefore, ought to be highly sensitive to changes in vega and delta. Yet, a European option is likely to offer enough liquidity for you to sell it even after the underlying moves up and the strike becomes in-the-money (ITM).

The author offers training programmes for individuals to manage their personal investments

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