OptionSage submits:
“Humans get complacent when they become too certain and panic when they become too uncertain” – Tony Robbins
Countdown to earnings… You can almost sense the anticipation and excitement ahead of earnings that is due to kick-off this week with Alcoa reporting. It’s customary that Alcoa kicks off earnings while Cisco draws the curtain on earnings. This earnings season my Inbox is being flooded by offers from Bernie Schaeffer and others regarding blow-out earnings and triple-digit earnings increases. Despite their proclamations, it’s impossible to know for sure which way a stock is going at earnings.
In fact, the best homework in the world might determine that a company should report stellar earnings but, if the analysts focus on something negative in a report, a stock can easily move in the opposite direction just as fast! Instead of trying to game the direction, we can take a different approach and seek out the stocks most likely to move drastically instead. That statement begs the question “Is finding the stock that moves with extreme volatility sufficient to make money?”
The answer is unequivocally “No!”. The reason is: Option prices often price in very big moves one direction or another so we have to find stocks that we will move beyond those priced into the options! For example if you were to consider a strangle on Alcoa next week using strike $42.50 long calls costing $1.30 and strike $40 long puts costing $0.85, the combined cost of the trade would be $2.15, thereby factoring in a move above $42.50 or below $40 by $2.15. From where the stock currently sits this requires a move up of at least 7% or down by at least 9% just to breakeven.
According to OptionSlam.com I see that only 5 of the last 10 earnings reporting periods the stock went up subsequent to the report while 5 times it went down. Of the 5 times it went up, only once did it rise significantly beyond the 7% required target (on January 09, 2007). Meanwhile of the 5 times it fell, only once did it fall well below the 9% target (July 10, 2006). That doesn’t engender much confidence in a strangle for this stock. But doing the homework has proved to be valuable; learning how to filter out a bad trade. It’s almost as important to filter out bad trades as it is to find real winning trades.
Moving on I might ask another question on strategy. “Do I really want to enter a strangle going into earnings?” Or perhaps I should consider something else, maybe a ratio call backspread. The ratio call backspread involves entering more long options than short options. You can think of an application of the ratio call backspread as placing a bear call in-the-money while placing a long call near-the-money or out-of-the-money.
This trade has many similarities to a straddle or strangle. In all strategies long options are purchased near-the-money but the difference with the backspread is that additional short options are entered which may have extrinsic value. That additional extrinsic value, in fact offers a means of entering a hedged trade similar to a straddle or strangle but potentially at lower risk. The ratio backspread profits in a downtrend due to the bear call (just as the straddle or strangle can profit in a downtrend due to a long put) while the additional long calls offer unlimited profit potential should the stock rise at earnings just like a straddle or strangle (note the bear call only has fixed risk so as a stock would continue rising, the ratio call backspread keeps making money due to the additional long call continually profiting – this is not the case as the stock would fall because only the bear call can profit in a downtrend and it only has fixed reward potential). The conclusion is that the ratio call backspread trade is in fact biased somewhat bullish.
With that background, let’s see if we can find a ratio call backspread with attractive reward to risk ratio and reasonable chance of making money. I emphasize the word “reasonable” because these are more speculative trades. There is never a guarantee that a stock will move significantly around earnings so hope for volatility is definitely a part of this trade! In fact I would go so far as to say that if you are a conservative trader than this type of trade is likely not for you!
One stock that I believe has been beaten down for a long time and has the potential to make some nice moves this earnings season is EBay. EBay had a great move after hours following its last earnings report but it didn’t amount to much and it’s been consolidating for a few months in the low $30s. I don’t expect that to last much longer as the fundamentals finally get noticed and the stock should reclaim the high $30s, low $40s again. What I don’t know is when those fundamentals will be recognized but I would be happy to take a chance on them this earnings season. (Of course that uncertainty is by definition what makes this trade somewhat speculative).
Trade #1
EBay stock currently sits between strikes $32.50 and $35 so we could place the short call of the bear call in-the-money and place the long call slightly out of the money. So too can we place the additional long call out of the money also. As earnings are on the 19th, the day before expiration, we can take advantage of the July volatility collapse
-
July Short Call Strike 32.50 Credit $1.80 *2
-
August Long Call Strike 35 Debit $.97 * 3
-
Net Credit = .69
-
Risk = $4.31
-
Should the stock decline to $32.50 per share or lower after earnings, the July options would expire worthless, leaving us with whatever value remains on the August calls plus .69. The July calls will lose .69 of extrinsic value on Friday, the 20th so a close at $35 or higher would have us owing our callers $2.50 each ($5) before running into our Aug $35 covers. That $5 would be mitigated by the value of our 3 in-the-money Aug $35 calls. If we assume they were to carry .50 of extrinsic value, then our break even on the trade would be approximately $37.81.
Between $32.85 and $37.81 you will owe money to your caller so this is a more bearish play but also plays well if you feel that the stock will not initially make a great move but will gather steam in August. This is the spread Phil likes as he feels it can be actively managed on earnings day to lower the risk.
Trade #2
The trade above requires a significant upward move to profit from where the stock currently sits. If you wanted to create a similar trade that does not require such significant upward movement, you could consider the following:
-
August Short Call Strike 27.50 Credit $6.40
-
August Long Call Strike 32.50 Debit $2.25 * 2
-
Net Credit = $1.90
-
Risk = $3.10
-
Should the stock decline to $27.50 per share all options would expire worthless and the maximum profit in a bearish trend, $1.90, would be attained. The stock needs to move either above or below $32.50 by at least $3.10 to start generating a profit i.e. $29.40 and $35.60 are breakeven points. Between $29.40 and $35.60 the trade is losing money while the trade continually profits as the stock goes above $35.60 per share. Obviously, this is much more attractive if you were bullish on Ebay with the current stock price sitting at $33.39.
Trade #3
Personally the trade I would be most happy with is a slight variant on the ratio call backspread mentioned above. Projections for EBay forward earnings for 2008 according to Zacks.com are $1.45. The current trailing multiple for EBay is 37 and I find it hard to believe that by end of fiscal year 2008 that EBay’s multiple will have contracted much more than 10% to 33 since earnings growth rate is still approximately 20%. The price target would therefore be 33 * $1.45 = $47.85 by expiration.
With that background I would consider a backspread that takes the form of a ratio bull call spread trade. The trade below comprises more long options than short options in a 3:2 ratio.
-
Long Call Strike Jan $27.50 Debit $10.10 *3
-
Short Call Strike Jan $35.00 Credit $5.90 *2
If the trade was not applied in a ratio format it would simply be a bull call spread with the following risk and reward potential.
-
Net Debit = $4.20
-
Max Reward = $3.30
The return on risk therefore is $3.30 of reward on $4.20 risk which produces a 78% return upon assignment of the short call at expiration. Despite the fundamental analysis above, the bull call could produce this attractive return provided the stock stays above $35 by expiration in January 2009.
However, the fundamental analysis above targeted a $47 price target so additional long calls are added to the trade to take advantage of the expected uptrend. Hence the trade has more attractive upside potential than simply holding a bull call while it has lower risk than entering LEAPS calls alone while we have lowered our break even point on the 3 Jan $27.50s to $33.60, 28% below our target.
Have a fantastic week!
OptionSage
