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Options for Earnings Plays

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Know the expectations.

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On face value, Google's options with an implied volatility of around 30% appear to be cheaper than Apple's. But when looked at relative to each stock's 30-day realized or historical volatility (HV), Google is actually more expensive. Google's HV is 16%, which means that the options IV is running a near 90% premium when compared to Apple's HV, which is 22%, meaning that its options are "only" a 45% premium. But again, you must monitor whether Apple's options IV creep higher heading into earnings. A great free site for tracking options volatility, both historical and implied, is iVolatility.com.

Since most options are going to see a decline in implied volatility following the earnings report, it is wise to use a spread rather than the outright purchase of options in making a directional bet. The profit potential may be less on an outsize move, such as Priceline's (NASDAQ:PCLN) $100 or 20% decline following its last report, but the probability of profit is much greater -- and of course, the loss will be of a more limited nature.

The next step is using that implied volatility level to determine what size price move is being estimated or priced into the options. This will help you determine which strike prices you might want to use in setting up your position. While some services such as Bloomberg and other premium sites provide that data, one can perform the calculation relatively easily. The down-and-dirty formula would be to simply take the price of the at-the-money straddle -- that is, add the price of the puts and calls, and divide that total by the price of the underlying shares.

For example, with Google trading around $741, the October $740 calls are trading $20 and the $740 puts are trading $19, giving the straddle a value of $39. This means that the options are pricing in at around a 5.2% price move. That is, $39/$741=5.2. Remember, the options only estimate the magnitude, not the direction of the price move.

Note that we are using the weekly options that expire this Friday, which makes this calculation much easier since time decay is a minimal factor because there will be only one day until expiration. This means that options will essentially revert to their intrinsic value. However, if we look at the November options that expire in 31 days, the straddle is valued at $51. But note that after the earnings report, these options will still have 29 days of time premium, which would amounts to around $11 in the straddle.

Given that most of the popular issues will have weekly options listed for their earnings reports, it would make sense for those looking for the speculative action of earnings plays to stick with the leverage of these short-term contracts. But remember, this leverage cuts both ways -- if you are wrong, expect to lose 100% of your allocated capital.

Twitter: @steve13smith

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No positions in stocks mentioned.

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