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Earnings Volatility

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Editor's Note: Minyanville is a community of people who share an interest of fiscal literacy. As perspective is an important aspect of our daily routine, we share this email with hopes that it adds balance to your process.

Hi John,

I was wondering, is there a proper way to play the lowly priced volatility in a stock during earning season? I have noticed that a lot of companies (Amazon.com (AMZN), eBay (EBAY), Lexmark (LXK), Yahoo! (YHOO)) have been moving more than their implied volatilities were predicting after they come out with earnings. But when I look at the price of the option, buying a straddle seems a bit risky to me, especially if the the stock doesn't move at all. I would end up losing on both sides of the trade and then the post earnings implied volatility crush would probably make matters worse.

Is it better to go long a put/call and go long/short the stock to balance out the position? This way I only end up paying a premium for one side of the trade. Is this what is called delta neutral trading? Is this what you tend to do when you buy "cheap" options in general? Stay delta neutral?

Thanks,
Minyan Jag R
Toronto, Canada.

To play the volatility of a stock, even when earnings come out, you should be set up professionally: low cost of execution, use the proper leverage, and trade within the context of a portfolio and commensurate risk. Trading volatility is all about probabilities and you must have a diversified portfolio to have the proper risk and reward. There are many stocks that do not react like an Amgen (AMGN).

That being said, we have noticed clearly that the new sellers of options, funds whose directive is to sell options and "generate income" are systematic and price insensitive. The normal increase in option prices before earnings has not been occurring in many stocks as a result of this systematic supply.

We find ourselves buying many more short-term options these days because the gamma/theta relationship is extremely favorable. One AMGN makes up for many small losers.

We are currently buying Bristol-Myers Squibb (BMY) August 25 options neutral (like a straddle) in front of earnings (not advice). Sellers look at the income. I look at the risk/reward. Even if it does not pay off it is a good risk for reward play.

position in amgn, bmy

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