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Trader Q&A - How Can I Hedge Against Known Unknowns Like Earnings Reports?

Schwab’s Randy Frederick discusses strategies to brace for events like earnings reports, elections, and more.

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Randy Frederick: Well, I'll jump on this one. And actually, I've written an article that's very much on this particular topic. One of the things - mistakes I think a lot of people make is they try to hedge unknown unknowns, which are things like that Lee was talking about earlier, which is spikes in volatility. We never know when a volatility spike is going to occur, and the big spikes happen to - tend to come from unexpected events, or like what we call black swan events.

Black swan by definition is something you don't know what will happen, when it will happen, or even if it will happen. And people spend a lot of time and lose a lot of money sort of preparing for that next big unknown, and it might be years before it happens, right?

So - but things like earnings reports, like election results, like FOMC meetings, we know the exact day and even almost to the hour of the exact time when these things are going to occur. So it's actually fairly easy to hedge against the events, because when you create a hedge, especially if you use option strategies, you have to keep them on. Every option has an expiration date, and if I know that a company that I own is about to announce earnings on Thursday, there's a very good chance that there's an option that expires the following day, on that Friday.

And putting on a strategy that will, if I'm concerned about a downside, maybe I buy a protective put. If I think there may be an upside move or maybe if I don't know which, and I just want to sort of hold tight through whatever volatility might occur from the earnings report, then I can put this strategy on. And if it's using options that expire the following day, then I can do it very, very cheaply.

So the main thing is - what I say is if you're trying to hedge a specific event, use the options that are the closest expiration immediately following the event. Then the whole process is very simple, very easy, and it's usually a whole lot cheaper, and then once the event's over, you don't have to worry about it anymore.

But the main thing is, and I think you know this by asking the question, is you can hedge the things you know when they're going to occur, even if you don't know the outcome. The things you don't know when or if they'll occur, frankly, very difficult. And I would encourage you to go look at the website, because I believe that article is still out there that talks about how to do that.

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