Track That Trade 110803 Earnings Plays

APA is announcing earnings tomorrow morning (verified with phone call to company).

Today the options should be attracting buyers, and that generally results in higher implied volatility and richer option premiums.

Let’s examine some possible plays – prior to earnings. We’ll include mistakes made by option novices. The primary purpose of making these trades is to help Members avoid making such mistakes. This page is being written at an elementary level and is more for beginners than seasoned trades.

If the option prices allow, I’ll point out a couple of plays that are typically made by more experienced traders. There are two main warnings:

  • These trades are not recommended. They are merely examples
  • These trades tend to be more risky, and potentially more rewarding, than other strategies discussed

The current plan calls for posting trades late in the trading day.

Volatility Background

This data come from the Option Strategist

hv20 is the historical stock volatility for the past 20 days

curiv is current implied volatility

days = number of trading days worth of data is available

%ile = percentage of the time that IV has been lower. In this example, over the past 600 trading days, current IV is higher than 48% of those days. Thus, it’s neither very high nor very low – as of last Friday (it’s weekly data)

Today’s numbers

Option quotes as of 9:30 AM CT

IV of the ATM (or almost ATM) options is 36. The stock price is 116.86

Option quotes as of noon CT

IV of the ATM (or almost ATM) options is still near 36. The stock price is 117.11

IV is about 20% higher than it was last Friday (using the numbers above). This is disappointing to me. Many times the IV surges prior to the news being released, and that surge makes trading both interesting and risky.

Possible trades

Option quotes as of 1:55 CTthe trader must not get trapped into believing these trades should be held longer – seeking larger profits. Holding may be ok in certain situations, but please understand that earnings plays are intended to be one-day trades.

Note: These trades are all designed to be held for the earnings only. In other words, it is an attempt to make a trading profit and

1) Simple play, betting on a market move in reaction to earnings:
Buying options. This is one way that the average retail investor handles earnings. With IV 20% above last weeks level, the prices are a bit elevated, but are not outrageous. I would NEVER make this play, but for someone who has an opinion – and wants to gamble on that opinion – neither of these options is too costly to consider. But if you do want to make such a bet, it’s imperative to have some familiarity with the stock, its reaction to past earnings news, and the likelihood of a significant price change. Because I am not familiar with any of that important information, the purpose of this Track That Trade is to illustrate and comment on trades made when news is pending.

IMPORTANT: After news, it is reasonable to expect IV to drop to ‘normal’ or less. Why? Because the likelihood of a big stock price change is much smaller after news is released. Remember that option buyers seek big moves, and when there is no news coming before the option expires, it is less desirable to own.

a) ATM options. A decent play, if you want to make the bet. [NOTE: I know nothing of this stock, so this is not a recommendation]

  • Buy Aug 115 put @ $2.49
  • Buy Aug 120 call @ $2.37

b) OTM options. This is where the novice goes wrong, hoping for a giant move. Many times the big moves occurs, but it is not big enough to overcome the elevated option price and the forthcoming decline in implied volatility.

  • Buy Aug 110 put ($1.11) or the Aug 105 put ($0.45)
  • Buy Aug 125 call ($0.98) or for the die-hard bull, the Aug 139 call ($0.37)
  • NOTE: Both OTM calls and puts have higher IV than the ATM options. This is unusual

c) Buy the strangle: buy the 115P and the 120C. This is paying a LOT of premium. Thus, if the big move does not occur, the trader is guaranteed to lose money – due to the decrease in IV and the passage of one day. Some traders love the idea of buying straddles and strangles into earnings. OI find it to be foolhardy.

It is easy to convince beginners to make this play. After all, this is a $120 stock and a $10 move should have a reasonable probability of occurring. Yet, the option prices are not sky-high, and few people are making that bet.

2) Selling premium, based on the fact that IV is high. I would not make that play here because the option prices are not high enough. Yet, let’s look at some choices – for the sake of discussion.

a) Sell vertical spreads spreads. This is one situation in which the iron condor is less attractive because of the increased chance of a decent-sized price change in APA. I’d prefer to go with only one side.

  • Sell Aug 125/130C and collect $0.52. Not a lot of cash, but if this stock does not rally, the trader should be able to exit tomorrow with a quick profit.
  • Same for Aug 130/135 call spread, but the available premium is far too small for me
  • Sell put spreads: Aug 105/110P ($0.65) or the Aug 100/105 ($0.24)

b) Sell strangles. This is quite risky, involving the sale of naked calls and puts. I’d stay away from this play. If the sale is so attractive that you must make it, please consider buying one call for every call sold and one put for every put sold – just for the sake of safety. Yes, profit potential is much less, but so is loss potential.

3) Diagonal spreads. 5-point spreads. The idea is to play for the Aug option to decline in value overnight – and for the September options to retain much of their value. But be warned. This trade has positive vega. It is not usually a good idea to own vega when anticipating a volatility decline.

This play is far more attractive when front-month options are trading with a MUCH higher IV than the 2nd month options. That important requirement is missing here.

Another negative factor (and it is linked to the first) is that this trade is made at a debit. Collecting credits is much more attractive.

Example of a trade that is unappealing (this time, but may look better in a different scenario):But Sep 130 call, sell Aug 125 call. These trades are typically made on a 1:1 ratio and are not delta neutral. In this situation, the trade would cost a small debit of ~$0.30. This is a reasonable cost for a non-bull, but it does not fit the guidelines. If we are going to take the risk of seeing the stock move on earnings move, we need a decent reward potential upfront. I don’t see that here.

The double diagonal is part of the ‘diagonal spread’ category and would be made with one call spread and one put spread. But not today. Not at these prices.

Option Volume

This stock turns out to be a poor choice. See the volume below. it is 15 minutes before the close and there has not been a lot of investor interest.

End of Day

Showing a lack of demand for these options, IV moves lower towards the end of the day. Calls a bit lower, puts a bit higher, than the opening.

Update: August 4, 2011

Looks like an non-event. Stock little changed in pre-market.

The Opening quotes

Stock opened 1.37 lower and that’s not going to be good for anyone who bought options.
The premium sellers won this time – as they do most of the time. That’s not an endorsement for selling options prior to the new release. It’s just a reminder that selling tends to be the winning strategy, but when it loses, the losses can be substantial. That’s why earning plays are high risk/high reward plays. But this time nothing special happened on the opening.

Trade results:
Implied volatility is lower, as expected. Anyone who bought calls or puts lost money. Straddle/strangle buyers fared even worse. No disasters, but an earning bet that failed to produce a windfall. In fact, if I had been an option buyer, I would not be too disappointed at the size of the loss. You could tell yourself that the play was worth the risk, even though the size of the potential reward cannot be known.

Sellers of OTM call spreads came out ok – because the stock opened lower. However, sellers of OTM put spread are not winners. The bid/ask spread is wide and it will be difficult to exit at a good price. The fact that the stock has declined is not going to help. This trade is going to be a loser. How much is lost depends on how stubborn the trader is when it comes to pulling the trigger and exiting the trade with a small loss. In other words, risk management is the key here, as will all other trades.

There’s not much to report on the diagonal spreads. No big wins or losses. IV is down, hurting owners of the Sep options, but Aug declined as well. The wide bid/ask makes it difficult to know the prices at which we could exit any position.

Bottom line, based on the market opening, and the small decline in the stock price, there were no big winners or losers in this earnings play.

However, those who held onto their positions face a different result, as seen below.

Twenty-Three Minutes Later

APA options 23 minutes after the market opens

APA is declining, along with the general market. Implied volatility is also rising, but is below the level of yesterday’s close. Put buyers who held onto positions can exit for a profit. That’s also true for OTM put buyers. Straddle owners and call buyers have not fared as well. Diagonal put spreads are facing a small loss, but are long a bunch of delta.

Later in the day data

10:17 AM

2:59 PM

Put buyers win, if they held all day. But that is contrary to standard ‘earnings play’ methods. Option buyers usually have to sell before implied volatility falls during the day. Today they collected a big bonus for holding.

2 Responses to “Track That Trade 110803 Earnings Plays”

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