Earnings and Options: Finding Profits AND Peace of Mind

By John A. Sarkett, Developer, Option Wizard

Earnings season, when a year's (or two years' or three years') worth of gains can vanish in a single moment of time.

But for the options strategist, earnings season can be a very different animal. Price movement and volatility, and the more the better, can be his or her best friend. What a contrast!

Some financial writers are comparing current markets to the bubble marketing of the late 1990s. High PEs, huge liquidity pumped into the system by the Fed. It may be instructive to revisit those heady times. Let’s review October, 2000 earnings season, for example.

Yahoo free fall

On its October 10, 2000 earnings date, before late p.m. release, Yahoo trades in the mid-80s (it would subsequently decline to 8 before rebounding to approach 50) in a tug of war. Yahoo bulls cite the fact that the Yahoo CEO refused to pre-announce bad earnings. The bears say "fine," but what about the future?

Big potential up and down!

How to position for the actual announcement then?

The potential for selloff is much greater than the potential for advance, since even stocks with great earnings are being sold off hard in the after-announcement market, yet to be naked short in a vastly oversold market is too much of a risk. (Our Scan Wizard software went short YHOO August 28 at 122 and never looked back.)

Since we are bearish, the answer:

Short YHOO stock at 84

Long YHOO October 85 calls @ 6.5. [A call is an option that gives the buyer the right but not the obligation to purchase the stock at the strike price.]

At 6.5, the implied volatility was then measured by Option Wizard at 125 vs. a "normal" 90-100, highly expensive, as is usually the case before earnings.) [Volatility is a measure of how much a stock moves up and down. It is the percentage a stock may be up or down one year from now based on past price movement.]

This is a bearish position with protection to the upside. The protection is a 50 delta. [Delta means change, the change in an option price for a $1 move in the stock.] At 50 delta, we will lose 50 cents for every dollar of upside move in the stock. To the downside, we will make 50 cents per dollar for every dollar of downside move in the stock, to 77.5 (84 stock - 6.5 call), then we will be 100 delta for the entire trade, dollar for dollar gain to the downside.

We lock on. The roller coaster pulls away. The stock moves considerably in the closing minutes, but the ups are covered by our calls, the downs by the short, so we have relative peace of mind.

The closing bell.

YHOO closes at 82.75.

30 minutes tick by. Then the news:

YHOO announces good earnings, meets Street expectations, and the stock pops up on Instinet.

Thank goodness for our calls.

But wait.

The conference call does not inspire confidence going forward, in fact, just the opposite.

Red Herring reports it this way:

"Yahoo (Nasdaq: YHOO) beat Wall Street expectations, but investors beat up Yahoo nonetheless. The investor mood is still ugly, even for leading Internet players.

"Yahoo, the first Internet media company to report third-quarter results, announced a 13-cents-per-share profit on Tuesday, a penny higher than analysts had expected, and $295 million in revenues, $15 million higher than Wall Street's predictions. But the good news didn't dam the flood of investor panic around slowing growth and overvaluation in the Internet sector. Yahoo shares fell nearly 21 percent on Wednesday to $65.38 and the stock is now 74 percent off its 52-week high of $250.06."

Indeed, YHOO opens the next day at 72.75, down 10+, and subsequently declines to a low of 54.75 by Friday of earnings week. The buzz stays profoundly negative, and the stock sinks below 50 the next week. (It would be three long years for the stock to return to this level.)

We cover at $52, so profit on the trade by more than $25 in just a few days. We value the Oct 85 calls at $0, just like expired insurance premium. They have done their job.

This trade works best in situations where the potential for movement is huge. The results are so large, however, a trader can scratch out or lose small amounts on several such scenarios in a row if such a positive result loomed in the future, as it often does.

The trade can be adjusted several ways, depending on the trader's forecast:

1. Long puts instead of short stock, i.e. a long straddle, a combination options position of long calls and long puts.)

2. Ratio spread to achieve delta neutral status. [A ratio spread is a combination options position with more calls or more puts, depending on the trader’s bias.] In this case, twice as many calls against the short position, i.e short 1000 YHOO shares, long 20 calls. Then, after earnings when the situation becomes clearer, take a long or short position by offsetting the errant side of the trade. In this case, even after the low of the first down day, there remains another 15+ points to go on the downside!

3. Backspread to achieve greater profit potential, i.e, give greater weight to trade either long or short to profit more from move in that direction. In this case, if the position was put on using only options, no stock, one would be long 3 puts for every two calls, for a 3:2 ratio, or 4:2, or 5:2, etc.

IBM: Batter Up

Every January, April, July, and October, the big stocks come up to the earnings plate one after another like the heavy hitters in the all-star game. Next up in this analysis: IBM.

Earnings date is Oct 17: The situation: market is nervous, risk is high, and IBM offers the same highly volatile, long-short opportunity as Yahoo. The stock trades around 112 on the day of October earnings. The October 110 calls were purchased for 6.5, the stock shorted at 112.

The report?: Here's how the media plays it:

"Technology giant IBM today reported third-quarter earnings in line with expectations, despite nominal revenue growth.

"Armonk, N.Y.-based IBM earned $2 billion, or $1.08 a share, matching consensus estimates from FirstCall/Thomson Financial. The company earned $1.70 billion, or 90 cents per share, a year ago.

"Sales rose 3 percent to $21.8 billion, compared with $21.1 billion a year ago. Analysts had predicted sales growth of 6 percent or more.

"Although the company met earnings expectations, revenue numbers show IBM still has a ways to go to recover sales momentum after three difficult quarters.

"Hardware revenue rose 4 percent to $9.5 billion from year-ago levels. Hard drive sales declined. Software sales fell 3 percent to $2.9 billion for the quarter, while revenue from IBM Global Services rose 4 percent to $8.2 billion, on continued strength in Asia.

"John Joyce, IBM's chief financial officer, tried to downplay disappointing sales in a conference call with analysts by focusing on earnings per share, which he said rose "20 percent over last year's third quarter."

"Joyce acknowledged revenue growth "was not at the pace that we wanted."

Nor what the market wanted:

The stock gets crushed, opens the next day at 95, tumbles to 90 immediately. The Dow is down 400 immediately, since another Dow Jones leader, J.P. Morgan is getting dumped. Panic is in the air, but an institution buys 1 million IBM shares in the 91 area, and the stock skips back up to 95 immediately. We cover our short at 95.5 for a one day 10 point gain. We count the 6.5 point loss in the 110 call as insurance premium.

It’s how you handle the losers

Sounds easy . . . just buy the calls, short the stock. (Or it’s equivalent, e.g. long puts.) But! -- every system, every model, every style, generates losers eventually. How you handle losers determines your ulimate success. Our technique fails us when we apply the technique to Intel. We short the stock at 35, buy the 35 calls. Intel relieves the anxiety with a positive report and moves higher. We exit the trade with a small loss.

But in trading, if we can win two out of three times, and exercise sound money management principles, we can generate profits. We win with YHOO, IBM, lose with Intel.

Sometimes the market becomes so nervous -- panicked -- you can become the insurer and make profit. You can sell both the calls and the puts.

The Sell Side

Such was the case with our last example: JDSU.

On October 25, instead of reporting a blowout quarter as was widely expected, Nortel Networks reports a revenues disappointment. The stock loses 20 points in a flash.

So, too, then does JDSU. On the day of earnings, Oct. 26, JDSU trades at 70, down from 100 just one day earlier. November 70 calls sell for 10, November 70 puts for 10, for a combined credit of 20 points, thus creating a profit-loss band of 50 and 90. If you sell the 20 points for a credit on the 70 strike, and held to expiration, you would not lose unless the stock was less than 50 or greater than 90.

JDSU sports a historical volatility of 80, on average. November calls and puts as quoted above were running an implied volatility of 120, according to Option Wizard -- 50% higher than normal, too high to be sustained. We decide to become the bank, the insurer, if you will. If we can stay in the 50-90 range, and see post-earnings volatility return to normal, a profit can be earned.

The straddle is sold for 20. The earnings report is positive, a surprise. JDSU closes the next day at 74.50, volatility regresses, and the straddle can be bought back to close it out for 17 -- a 3 point gain, one day. [Option Wizard Scan generates 20, 50 and 100 day historical volatility readings, and calculates implied volatilities for comparison.]

Getting the Grades

Every three months, when earnings season comes around and corporate report cards come out, the stock and options markets provide daily opportunities for creative options strategies. Four months, 20 days each, 80 days a year for these kinds of strategies. So do the homework, do the math, as they say. Make your forecast, apply the appropriate strategy, and above all, employ risk management techniques.

Whatever your favorite companies get, As or Fs, or something in between, you yourself will stand an excellent chance of getting your share of A’s, and increasing your GPA (gross profit accumulation) over time, as well as increasing your peace of mind.

Designer of Option Wizard Online [free trial at http://option-wizard.com] and Scan Wizard [http://option-wizard.com/scanwizard] software, and author of Option Wizard Trading Method, John A. Sarkett writes on and is active in equity and options markets. Reach him via jas@option-wizard.com.