One of the most useful
characteristics of options is their ability to control risk and achieve a
high probability of success when trading impending earnings announcements.
Google will announce third
quarter earnings after the market closes on Thursday. It does not take a
conspiracy theorist to recognize that the following day, Friday, is the last
day to trade October options. Given this timing, options trades can be constructed
with near surgical precision to reflect the trader's hypotheses regarding the
price reaction to the earnings release.
I thought it would be helpful
to review some of the data that an options trader should consider prior to
constructing an option trade to profit from this event and to consider some
other potential trades.
First, the recent history of
stock price move on earnings release must be considered. The reaction of
price over the last four quarterly releases has been +8%, +7%, +2% and +3%
with the two lowest numbers correlating with the two most recent earnings
releases.
The second factor to consider
is the information embedded in the current pricing of the options chain. The
easiest way to determine the aggregate opinion of the overall option market
as it relates to the expected move following the earnings release is to
calculate the value of the front month at-the-money straddle discounted by
roughly 15%. It is important to recognize that this value is reflective of
the anticipated magnitude of the move and gives no information whatsoever on
the direction.
In the case of GOOG, closing
prices on Monday with GOOG trading around $740 give a value of
($19.90+20.80)*0.85 = $34.60. This equates to roughly a 5% move or a
projection with a 68% probability (1 standard deviation) that the price
movement will be bounded within this range.
Option positions to trade
earnings can be based on two general considerations: directional or
non-directional. Directional based trades can be constructed using a variety
of approaches, but MUST account for the collapse of implied volatility
following earnings release.
To be blunt, this means that
simply buying only puts or calls in the front month series is not putting
probabilities on your side. Appropriate directional constructions would
include vertical spreads, butterflies, and calendars. Each of these trades
either mitigates or benefits from the inevitable collapse of implied
volatility immediately following the earnings release.
Playing earnings directionally
is a difficult game. Recent market history is replete with unanticipated
earnings misses and unforeseen earnings blow outs. For those who wish to play
these announcements directionally, I feel the major value of an options
approach is to control risk crisply since there will inevitably be
unpredicted and unpredictable price reactions.
My preference is to use
strategies that are profitable over a wide range of prices. The potential
constructions in this category include iron condors and double and triple
calendars. Such trades do not deliver the overwhelming returns of a correct
prediction of price direction, but over a large series of trades result in a
high probability of success.
The trade I would like to
consider is that of a triple calendar spread. We will buy the December series
options, and sell the October series with dramatically increased implied
volatility as a result of the impending earnings release.
The GOOG October monthly
option chain is displayed below:
The strikes highlighted above
would be sold-to-open in this spread while the strikes shown below would be
bought-to-open simultaneously to produce the calendar spread discussed above.
The GOOG December monthly
option chain is displayed below:
Calendar spreads are usually
constructed by selling the near month put or call and buying the same strike
in the preceding month. In this case, note that the November options trade
with substantially higher implied volatility than do the December options as
a result of "bleed over" of the elevated October volatility.
The GOOG Triple Calendar
P&L curve is presented below:
This trade is short term and
is designed to be closed on this coming Friday (10/19/12). Note that the
break even points for the trade are around $670 and $840 respectively. These
break even points are outside of a double of the expected move. Based on the
current implied volatility driven probabilities, this trade has an
approximate 90% chance of successfully producing a profit.
This is not the elusive
"free money" trade either. Since we have discussed that trade for
several weeks, I think the reader gets the idea there is no such thing.
Option trading success comes from constructing high probability trades and
executing these trades in sufficient numbers that the statistical law of
large numbers delivers the predicted success rates.
A corollary of this is not to
"bet the farm" on any one trade. While we typically choose high
probability trades, there is no such thing as "free money" and a
low probability event cannot be allowed to curtail your trading career.
Happy Trading!
Simple ONE Trade Per Week
Trading Strategy? Join www.OptionsTradingSignals.com
today with our 14 Day Trial.
