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Options for Earnings Plays

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Know the expectations.

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MINYANVILLE ORIGINAL The wave of quarterly earnings reports is beginning to wash across traders' screens and it won't crest for another week. For some active traders, these jolts of information and the accompanying stock price movement represent terrific short-term money-making opportunities. And many will try to juice the returns by using options.

Before getting to some of the concepts and strategies that can be employed in playing earnings reports, let me provide the caveat: All earnings plays are extremely speculative and should only involve a minimal allocation of risk capital. The challenge in trading earnings is that there are many variables that need to be accounted for and correctly forecast.

Not only must you determine if the company will meet estimates (and whether those estimates recently been lowered or raised) and what kind of guidance will be provided, but you also must determine what has already been priced into the stock, and whether it has recently run up or sold off. And most importantly for our purposes, you must determine what percentage price move the options are pricing in as measured by their implied volatility (IV).

For example, look at UnitedHealth Group (NYSE:UNH) this morning. Despite delivering better-than-expected results and a mostly positive outlook, shares are off some 2% at the opening. Is this sell-off simply a pullback after a nice run in which UnitedHealth had rallied some 12% since being added to the S&P 500 Index (INDEXSP:.INX) one month ago -- or is it a sign that investors are truly concerned? Will Google (NASDAQ:GOOG) -- whose stock has run up approximately 27% during the past six weeks -- suffer a similar sell-the-news reaction following its earnings report this Thursday?

Imagine the game of "what is baked into" Apple's (NASDAQ:AAPL) earnings next week with the ingredients including its recent 10% sell-off, the speculation surrounding the iPad mini release, and iPhone 5 sales. I expect the implied volatility for Apple options, which have already increased by 25% to 38% over the past two weeks, to be near 52- week highs, and near 43% by the time it reports next Thursday. And then -- no matter what the results or response -- expect implied volatility to decline back towards the mid-30s level.

Prepare for Post-Earnings Premium Crush

The tendency for a post-earnings premium crush (PEPC) to occur makes understanding the relative "expensiveness" of options and the magnitude of the price move being priced in crucial to improving the probability of achieving a profitable trade.

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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