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A Look at eBay and Google
October 15, 2013 02:30 PM
OPTIONS FOR EARNINGS
we took at look at how options get priced prior to and after earnings reports. Now let’s see if we can apply these concepts to specific situations.
(EBAY) is set to report after the close on Wednesday and
(GOOG) after the close on Thursday. Let’s break them down, walk through the steps and see what strategies might make sense.
eBay in the Middle
Shares of eBay are trading at $54, essentially in the middle of their 2013 range between $50 and $57. That’s right, for 10 months shares have been in a $7 or 12% range and flat on the year. Will this earnings report bust it out of the range? The options are pricing in a $3 or 5.5% move.
I arrive at that number by looking at the at-the-money straddle. In this case the $54 put and $54 call are both trading around $1.50 a contract. If the market makers have it right that would place shares at $51 or $57 after the earnings report.
Implied volatility is now at the upper end of not only the 52-week range but also a large premium to the 30 day historical volatility.
The averge post earnings move over the past six quarters has been 4.9%, below what is being priced in. And this includes 7.2% moves - both down - over the past two quarters, but these came as shares had run up to highs prior to the report. I believe these options are overpriced. I think both the stock will remain within the recent range and therefore options will have a severe post earnings premium crush (PEPC™) I’m looking to sell premium into the report.
I would do this using an iron condor. This consists of simultaneously selling both a put and call spread. Using spreads limits the potential loss in case things go hooey. This is what the position would look like:
-Sell October $56 calls at $0.70 a contract
-Buy October $58 calls at $0.25 a contract
-Sell October $52 puts at $0.75 a contract
-Buy October $50 puts at $0.30 a contract
Each of these spreads are being sold for a 45c net credit. Meaning the iron condor is being established for a 90c net credit. It represents the maximum profit that would be realized if shares are between $52 and $56 on this Friday’s expiration.
The maximum loss is $1.10; calculated by the width between strikes of each spread minus the premium collected or $2-$0.90= 1.10.
Getting a nearly 1:1 risk/reward on an iron condor, especially one that will be zapped of nearly all it’s time and implied volatility premium following the event looks attractive.
Google Ready to Butterfly
Shares of Google have enjoyed a very nice bounce over the past week, jumping some 4% to the $880 level. But the stock still remains some 7% below its all time high set in July even as the Nasdaq (QQQ) sets a new high today. In that sense, Google has been a laggard, and leads me lean towards a bullish position on the belief that good numbers could propel shares back to the highs near $920 a share.
The options, based on the $880 straddle, are pricing in a $33 or a 3.5% move. This would project up to $913 and down to $847 a share. The options are actually somewhat “expensive” compared to historical volatility, but relatively on the low end of the premiums typically awarded prior to earnings. On average, the stock has experienced a 4.1% move over the past six quarters.
I think shares of Google could exceed the expected move. That said, buying volatility prior to a report is a highly speculative and I want to minimize my risk in case both my direction and magnitude are wrong. This can be done by using a butterfly spread.
A traditional butterfly with a 1x2x1 construction of strikes that are equidistant a skip strike. But in order to expand my profit zone, and reduce cost I‘m looking at using what is referred to as a skip-strike or broken wing butterfly. For example:
-Buy 1 October $890 call at $12.20 a contract
-Sell 3 October $920 calls at $3.70 a contract
-Buy 2 October $935 calls at $1.75 a contract
This adds up to a $4.60 net debit for the 1x3x2 butterfly. The maximum profit of $25.40 would be realized if shares are at $920 on this Friday’s expiration. That is calculated by the width between the lower strike (890) and the middle (920) minus the cost of the spread. 35-4.40=25.40
The maximum loss is the cost of the spread ($4.60) would be incurred if shares are below $890 or above the $935 on Friday’s expiration.
These butterflies are often hard to land right on the number, but with the cost lining up with a target price the risk/reward of over 5:1 seems very attractive.
I have not entered either of these trades yet so at the moment they are for demonstration purposes only. But this is what I’m thinking.
No positions in stocks mentioned.
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