I spent yesterday writing mostly about how I wouldn't play an earnings name. Which, of course, begs the question, how would I play an earnings name?

I strongly believe in defining risk. In an options context, that means I want to put on only plays where I have no "naked" call or put exposure. Any bet on a reaction is either a bet on volatility, or a bet on direction. Any option play at any time is a bet on direction and/or volatility, of course; the difference is that the risk of a outsized gap is extremely low on a random day, so it's less worrisome to have exposure. On an earnings day, that risk is considerable; there's about a 1-in-3 chance of moving over one standard deviation alone. So, I'd simply rather not gamble on a real outlier, and fortunately there are plenty of ways to play that defined risk.

You don't have to put something on that has a name -- you can use any ratio and any combo of expirations you like. But for ease of example, I'm going to stick to a couple of popular spreads.

If you don't have a strong directional opinion, but want to bet against a big move, nothing beats selling an iron condor, in my humble opinion.

Here's a look at the play in Buffalo Wild Wings (NASDAQ:BWLD), set so to report on Feb. 12 (click to enlarge):

With the stock about $77, we "sold" the February 85-90 call spread and the February 70-65 put spread eight times each. The red line shows the profit/loss (P&L) at expiration, but it's a pretty simple profile. If BWLD closes anywhere between $70 and $85, you earn the entire premium taken in. In this example, that's about $2,000. From $85 to $90, and $70 to $65, we erode our profit, then lose outright on every tick, maxing out at about $3,000.

You can, of course, tweak the numbers and lean one direction (sell only four put spreads, for example). You can also turn it into a long bet on volatility by buying the iron condor instead of selling it, etc. If I were expecting a big move though, I think I'd rather just go net long either calls or puts or both (a strangle, maybe) and take a shot at a real outlier move with unlimited upside P&L.

If instead of betting on volatility, I wanted to bet on direction, I would just sell verticals. If I liked BWLD e.g., I would just sell put spreads. The more I bullish I felt, the closer I would go to the current stock price. Butterfly spreads can behave pretty similarly and perhaps widen your profit range. Here's one in BWLD (click to enlarge):

Here we buy the February 75-80-85 butterfly eight times. It maxes out at about $4,000 if BWLD expires at $80. On the risk side, we can lose a max of $1,000 under $75 or over $85. Again, we can tweak it by selling fewer 80-strike calls, buying a put butterfly at lower strikes, et. al.

These are my favorite sorts of risk-defined earnings plays. Coming soon, plays I'm not quite so enamored with.

Disclaimer: The views represented on this blog are those of the individual author's only, and do not necessarily represent the views of Schaeffer's Investment Research.