How to Trade on Events: Define the Risk vs. Reward  

Over the years, we have seen many a market event du jour or “event of the day” that will often spur strong stock movements.

Years ago, all eyes were on the trade balance. Then there was the money supply; durable goods; and the unemployment report. And now, the most watched event is any scheduled Fed announcement or release of the FOMC minutes.

Before I begin discussing ways to trade these events, let me say that I am not advising or recommending any of these strategies. I am pointing them out as solid risk vs. reward ways to trade a particular event.

For smarter trades subscribe to Tradespoon!

I will very seldom take a purely directional view on a pre-event situation unless I am convinced that the consensus view will be wrong. In that case, I buy a vertical call or put spread. If I think expectations regarding XYZ earnings are too optimistic, I will buy a put spread. And, if I think a stock has been beaten down too far ahead of an announcement, then I am a call spread buyer.

I very seldom buy options outright either, as volatility tends to be high pre-event and then collapses like a bad soufflé after the news is out.

The old market adage, “buy the rumor, sell the news,” is often spot on. Say, for example, it’s been long rumored that XYZ will raise its dividend and the stock has been moving higher. XYZ does indeed raise its dividend, but the stock has already had its move and then settles down or even goes lower.

Let’s look at two other event strategies: Say I think there has been too much market volatility ahead of a Fed announcement. I can do an index iron butterfly:

I am basically short the at-the-money (ATM) straddle (strike B) and am long the A/C strangle.  I am saying that the ATM straddle will collapse in price once the news is out faster than my out-of-the-money strangle.

A variation, or tweak, on this strategy is to do it in a bit of a ratio. Let’s say I sell the straddle 10 times but then buy the strangle 11 times. This reduces my credit received somewhat, but gives me some potential if I’m wrong and the index blows through strikes A or C.

But, what if I think the market is too complacent ahead of an event? Let’s say everyone knows XYZ earnings will be within one cent of analyst expectations and not a lot of movement is priced into the options. In that case, I may look at the double diagonal.

In this trade, I am short an OTM strangle in the front month and long an OTM strangle in a back month. I have done both a put diagonal and a call diagonal spread. My view is that once the news is out the front month, out-of-the-money options will decay faster than my long farther term options.

Take note of the event strategies I’ve just outlined. You’ll notice that all have well defined risk/reward ratios, and all are hedged if you are wrong.

For smarter trades subscribe to Tradespoon!