In case you missed it tonight, my friends at LightSpeed Trading hosted a Webinar where I presented my thoughts on the uses of options in earnings season. Below please find the notes of the presentation (hope to have copy of the webinar to send out soon), all trade structures detailed were used as examples for educational purposes:
Lightspeed Webinar
The most attractive uses for equity options for the avg investor is for Risk Management, Yield Enhancement, and Leverage. In this webinar, I hope to touch on all 3 points, but given that we are just starting earnings season, I thought it may be most useful to touch on how I use equity options to express single stock views around a potentially volatile event such as an earnings report.
Anatomy of an Earnings Trade With Options
1. Determine the implied move using weekly options, walk through back of the napkin calcs and also walk through our implied move calc.
2. Determine historical avg moves following earnings.
3. Develop directional thesis using the following inputs:
a. Implied move vs historical
b. Fundamentals; valuation, product cycles, competitive pressures, corporate action etc
c. Sentiment; analyst ratings, price targets, short interest, change of estimates
d. Price action and technicals, have a view on where the stock has been and where the charts suggest it could be going.
e. Volatility, get a sense for what base vol should be in the name, and where it is likely to settle after the event, this is tied to the implied move, but when evaluating different structures and expirations to express the view.
4. Once Directional thesis and vol view established, arrive at the the most cost effective way to express the view. In some instances we will arrive at the conclusion
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Example
JPM ($41.50)
1. Implied move:
Stock 41.50 the Oct12th weekly 41.50 straddle is offered at 1.25, the Oct12th 41.50 call is offered at .62 and the Oct 41.50 Put is offered at .63
If you bought that straddle you would need 1.24 move either way from 41.50 on Fridays close, thats ~3%, thats the implied move.
Here is a link to our Implied Move Calculator. http://staging.staging.riskreversal.com/analytics/ The Calculator helps us give an approximate estimation of the priced move the options market if the listed strikes don’t fall close to the spot price of the equity or if there are no weekly options.
2. Historical moves:
Now I want to look at historical, how does the options market view this report vs the past performance. Bloomberg screen below shows that the average move over the last 4 qtrs has been 4.25% and 2.8% over the last 8qtrs. The implied move is cheap compared to historical:
3. Fundamentals:
Positives:
- Stock trading 0.85x book, at a 9 P/E, and a 3% dividend yield
- QE3 is a huge boon to investment banks who can “front-run” the Fed and yield securities profits
- Lending growth has strong in the past year, and the housing market helps JPM, who has 25% of loans with exposure to residential real estate in the U.S.
Negatives:
- Investment banking revenues seem to be in secular decline, with trading margins significantly compressed and volumes near 5 year lows
- Reserve releases against bad loans have been used to prop up earnings over the past year, leaving fewer reserves as cushion for potential bad times
- Asset markets have been quite fickle over the past 3 years, and any downturn is especially felt by banks, who old a large amount of assets exposed to financial markets
4. Technicals:
The 1 yr chart is actually fairly constructive when you consider the stock has had three 30% plus moves this year alone, and now appears to be knocking up against the downtrend line, above the $40 support level and about to break the declining wedge. On any broad market move lower, or negative stock specific news, the stock should find some support at the previous level where it based in August and possibly just above that at about $38.30 which corresponds with the uptrend line from the June lows and its 200 day moving average.
5. Sentiment:
Wall Street analysts are fairly Bullish on the stock with 27 Buys, 11 Holds and only 3 Sells with an average 12 month price target of $45.29. Short interest sits at a measly 1.25%. Earnings estimates have been trending a bit higher over the last couple months (see red line on chart below).
6. Volatility:
JPM implied volatility is trading almost 4 points off of the 52 lows which it hit in early May, prior the company’s acknowledgement of the losses from their CIO’s office. What’s interesting though is that implieds are trading at a premium to the 30 day and 60 day realized, which makes some sense with the stock’s recent rally, and much of the fears of large “Whale” losses out of the way. So realized has slowed down, and implieds are elevated because of the earnings event.
Options Chains From LightSpeed:
Oct12 Weeklies
Oct20 Regulars
Nov17 Regulars
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Trades to Consider:
1. Buy the Move:
First Trade Structure: If you didn’t have a directional bias, but thought the one day move price was too cheap, you could buy the at the money weekly straddle.
TRADE: JPM (41.50) Buy Oct12th weekly 41.50 straddle for 1.24
- Buy 1 JPM Oct12 wkly 41.50 call for .62
- Buy 1 JPM Oct12 wkly 41.50 Put for .62
Break-Even On Friday Expiration:
- Profits above 42.74 and below 40.26
- Losses of up to 1.24 if stock btwn 42.74 and 40.26, Max risk of 1.24 at 41.50
Trade Rationale: You are essentially betting that at some point this Friday or on the close that the stock would be below 40.26 or above 42.76 or about 3% in either direction.
This is a trade where the likelihood of losing all the premium that you spend is not great as there is a high probability that one of these options will be in the money on Friday and you would have to make a decision to close one leg if the stock does not have an out-sized move. You also have to be cognizant of closing the leg that is in the money or you could be assigned, and if the stock is pinned to the strike you may want to close the whole position to ensure you do not end up with the position you do not want on Monday morning.
Second Trade Structure: Another way to “buy the move” on earnings is to buy the front month weekly option, and sell a farther out expiry option. This would be selling a calendar.
TRADE: JPM (41.75) Sell Oct12th weekly / Nov 42 call calendar at .70
- Buy 1 JPM Oct12 wkly 42 call for 0.53
- Sell 1 JPM Nov 42 call at 1.23
Break-Even On Friday Expiration:
This is a trade where you are rooting for a big move in either direction. Why either direction? Suppose JPM rallies to 46. Then your Oct12 wkly 42 call will be worth $4 on Friday, Oct 12th expiry. Meanwhile, your Nov 42 call will have lost a lot of its time value, so it will probably be priced around $4.25 on Friday, Oct 12th, after the move has occurred. You can buy back your short call calendar for $0.25, after having originally collected $0.70 on it.
Now suppose JPM sells off to $38. Your Oct 12th weekly call will be worthless on Friday, but your short Nov 42 call will probably be worth around $0.25. Once again, your short calendar position can be bought back for $0.25, yielding a similar gain to if the stock rallied to $46.
Your main risk on this trade structure is that the stock does not move much. If JPM closes on Friday around $42, your Oct 12th wkly call will be worthless, but your short Nov 42 call could be worth around $1. In that case, if you closed out the position, you would have a $0.30 loss, since you collected $0.70 at initiation, and paid $0.30 to close the position.
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2. Sell the Move:
You could conclude that the options market is overpricing the potential move in the stock and you could do any of the following.
Trade: JPM (41.50) Sell the Oct12 weekly 41.50 straddle at 1.24
- Sell 1 JPM Oct12 wkly 41.50 call at .62
- Sell 1 JPM Oct12 wkly 41.50 Put at .62
Break-Even on Oct12 wkly Expiration:
- Profits if the stock is btwn 40.26 and 42.74 you make the difference btwn the premium you sold and the cost of buying back the straddle.
- Losses if the stock is below 40.26 and above 42.74.
Trade Rationale Believe it or not, while there is higher risk to selling the straddle as the risk is not defined, there is a higher probability of success, because no matter what happens, vols will come in after the event. And once the defined range is set the options that are set to expire at 4pm will start to decay very quickly and just trade a a few cents over parity=they will trade like stock. The main risk to this trade is that the stock has an out-sized move and you will either be effectively short stock if trading through you call strike
Second Trade Structure: Another way to “sell the move” on earnings is to sell the front month weekly option, and buy a farther out expiry option. This would be buying a calendar.
TRADE: JPM (41.75) Buy Oct12th weekly / Nov 42 call calendar for .70
- Sell 1 JPM Oct12 wkly 42 call for 0.53
- Buy 1 JPM Nov 42 call at 1.23
Break-Even On Friday Expiration:
This is a trade where you are rooting for a small move or no move at all. As I explained above related to selling a calendar, when the stock makes a big move in either direction, the call calendar position will lose value. So if you are buying the calendar, your hope is that the stock moves very little on earnings, and you can close out the position on Friday expiration for a gain.
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3. Take Advantage of Elevated Implied Vol in Weeklies:
In Front of an event To Add Yield and Leverage to an Existing Long Stock Position.
TRADE: Against A Long Stock Position in JPM (41.85) Buy Oct12th wkly 43/44 1×2 Call Spread for .10
- Buy 1 Oct12 wkly 43 call for .22
- Sell 2 Oct12 wkly 44 Calls at .06 for a total of .12
Break-Even on Friday Expiration:
- Profits of the stock btwn 41.85 and 44.
- Profits of the 1×2 Call Spread btwn 43.10 and 45, make up to .90, max gain at 44 of .90.
- If stock is above 44 on Friday’s close, your long stock will be called away at 44, so you have made 2.15 in the stock, but you have also made .90 in the 1×2 call spread.
- Think of the trade as a levered over-write, a sort of super yield trade.
- Losses from the long stock below 41.85, plus the .10 in premium that you paid for the 1×2 call spread.
Trade Rationale: You would only layer this structure on a long if you had confidence that the stock would go higher after earnings with the strong possibility of an out-sized move to the upside. You would also have to be comfortable with the fact that your stock could be called up away up essentially 5% in 2 days. So the cost of the short term leverage (besides the .10 premium) is the fact that you are capping your gains up 5% in 2 days.
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