Thanks for all those that attended. For those that couldn’t catch it live, here is a link to the archived version
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Webinar: Trading Q1 Earnings With Options, JPM, GOOG
Those who attended our AAPL webinar presentation from January are familiar with our earnings checklist when considering an options trade:
Anatomy of an Earnings Trade With Options
1. Determine the back of the napkin implied move calculations using weekly options, then walk through our Implied Move Calculator which uses the next two months to calculate.
2. Determine historical average 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 in 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 that we have little edge after evaluating the event from both a qualitative and quantitative approaches and decide not to play.
1. Implied move:
With GOOG at ~$775, the Apr20th 775 straddle is offered at ~$45.50.
If you bought that straddle you would need a $45.50 move up or down by Friday April 20th’s close, which is about ~6%, but that’s not the implied move for the earnings event. Embedded in the price today, there are about 9 trading days of time value in the straddle in addition to the “event” time value.
HOW DO WE DETERMINE THE “EVENT” MOVE?
1) If the earnings fall in a week where there are weeklies options, you can pretty much take the at the money straddle price as a decent estimate of the event move.
2) Like in GOOG’s case today, if the event is not this week, we need to back out the one day “event” using our implied move calculator (For a rundown on these calculations please visit our discussion here).
Here is a link to our Implied Move Calculator. 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 and to get sense for how much of the straddle price is time value.
2. Historical moves:
Now we want to look at GOOG’s historical moves following earnings. How does the options market view this report vs the past performance? The average move over the last 4 quarters has been 5.15%, and it has been 7.25% over the last 8 quarters. The implied move of ~5.8% is not far from historical in that sense.
Positives: Plain and simple, near monopoly on their core business which accounts for more than 75% of their sales, fortress balance sheet with 20% of their market cap in cash, trades at a PE/G of ~1 with sales expected to grow at a similar mid-teens rate for the next 2 years. The stock while not cheap compared to most large cap tech, maybe unappreciated if they are successful in their focus to diversify away from their core desktop search, make the slightest headway in Social, push deeper into branded mobile products like Nexus, continue to scale YouTube and have any unexpected success in their 20% investments like GoogleGlass to name a few.
Negatives: The major tenets of the bear case is that their core business is under assault from FB, Twitter, MSFT, YHOO, AAPL etc etc. They have the share to lose in their core desktop search business and have shown little ability to make a dent in markets like China where they fiercely battled locals like BIDU. Monetizing mobile search is far less profitable than desktop and the field is far more crowded, often dominated by the device maker of the mobile product.
Enis went through the technicals on GOOG in his Chart of the Day post from April 5th. Here is the meat of the post:
The lifetime chart of GOOG shows the importance of the 750-775 area:
Lifetime daily chart of GOOG, Courtesy of Bloomberg
I’ve drawn the red line at the 2007 high around 750, and the stock sold off from a similar area in late 2012 after a weak earnings report. I would expect that level to act as support in the near-term, but GOOG reports earnings on April 18th, and that could be the catalyst for a big move in either direction, technicals notwithstanding.
Zooming in to the 3 year chart, more important long-term support lies at $650:
GOOG 3 year daily, Courtesy of Bloomberg
I’m not saying that I expect the stock to sell off down to that level. Rather, just an observation that if the stock were to get to 650 at some point this year, I would view that as a very favorable risk/reward long entry level.
In the meantime, GOOG is in a bit no-man’s land, with 750 important near-term support, and the all-time high at 844 the upside resistance, with the psychological 800 level maybe a footnote in the technical handbook for now.
Wall Street analysts are fairly Bullish on the stock with 30 Buys, 15 Holds and only 1 Sell with an average 12 month price target of ~$875. Short interest sits at a measly 2% of the float. GOOG made new all-time highs in February and March, so sentiment from that standpoint is not depressed. But options volumes have not shown the same euphoria. Its call to put open interest ratio has consistently been below 1 for most of this year, meaning there is more open interest on put options than on call options. Its option volumes have similarly seen heavier volumes on the put rather than call side. Overall, no clear bias in sentiment is probably the right assessment here.
The chart below shows that the 30 day realized volatility (blue line) is at 2 year lows, while 30 day implied volatility (red line) has moved higher in anticipation of the earnings event.
This chart on its own makes us lean towards a structure that is biased towards selling volatility rather than buying it. Of course, our decision on a final options structure involves incorporating our other inputs as well.
Trades to Consider:
A) NO EXISTING STOCK POSITION
Looking at all of our inputs above, my bias is to trade a short volatility structure that targets the 750 to 850 range, since the stock has remained in that area over the past 2 months, and 750 is long-term support. With that in mind, what’s the best structure?
-Buy a 750/800/850 call butterfly: This targets the midpoint of my specified range. We’ve done this type of in-the-money butterfly trade more frequently on the site because it is a way to sell volatility, but still offers a chance to more than double your upfront premium. (In contrast, selling an out-of-the-money call spread and an out-of-the-money put spread, known as an iron condor, usually risks more than it can make.) But which maturity should I choose for my butterfly?
-The Apr20th 750/800/850 call fly costs around $15.50
-The May17th 750/800/850 call fly costs around $13.50
-The Jun21st 750/800/850 call fly costs around $12
However, while the June call fly is cheaper, it will take much longer to make money than the April trade. In one sense, it’s less risk since it’s less upfront premium. In another sense, it’s more risk since there is more time for GOOG to potentially move outside of my desired range.
Though I haven’t traded anything in GOOG yet, if I were to trade a butterfly today, I would likely choose May. I am always nervous relying on only the earnings move to make a profit on my trade. By choosing May, I give myself more time for GOOG to “mean revert” to its recent price range in case it does make an outsized break in either direction due to earnings. But I don’t have to wait as long to make profits as I would by choosing June.
Trade: GOOG (~$775) Buy the May 750/800/850 Call Butterfly
- Buy 1 GOOG May 750 Call for around $42
- Sell 2 GOOG May 800 Calls for around $16.50 each
- Buy 1 GOOG May 850 Call for around $4.50
Break-Even on May Expiration:
- Profits btwn 763.50 and 836.50, with max profit of 36.50 at 800 on May
- Losses of up to 13.50 between 750 and 763.50 and between 836.50 and 850, with max loss of 13.50 at 750 or below and at 850 or above
B) AGAINST EXISTING LONG STOCK POSITION
1. Take Advantage of Elevated Implied Vol Ahead of Earnings: Yield Enhancement
In Front of an event To Add Yield and Leverage to an Existing Long Stock Position.
TRADE: Against A Long Stock Position in GOOG (~$775) Buy June 830/860 1×2 Call Spread for ~Even Money
- Buy 1 GOOG June 830 call for 11.00
- Sell 2 GOOG June 8.60 calls at 5.50 each or 11.00
- Profits of the stock of up to $85 btwn 775 and 860.
- Profits of the 1×2 Call Spread btwn 830 and 860 of up to $30, max gain of $30 with stock at $860 (added close to 4% yield with stock up ~11%)
- If stock is above $860 on June expiration, your long stock will be called away at $860, so you have made $85 in the stock from the current level, but you have also made $30 from 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 775, plus the in premium that you paid for the 1×2 call spread, in this case None.
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 possibility for the stock to meet resistance around its prior high.
2. Put Spread Collar Against Long Stock – Risk Management
TRADE: Against A Long Stock Position in GOOG (~$770) Sell May 810 Call to Buy May 750/700 Put Spread for Even Money
- Sell 1 of the May 810 Calls at 12.00
- Buy 1 of the May 750 Puts for 18.00
- Sell 1 of the May 700 Puts at 6.00
Break-Even on Expiration:
- Stock Profits of up to $40 btwn 770 and 810, max gain of $40 or 5% at 810 higher as stock is called away.
- Losses of up to $20 btwn $770 and $750, losses below $700 of stock, but you have made $50 on the put spread, so really you risk $20 (2.5%) btwn $770 and $700 (down ~10%)
Trade Rationale: You would do this against a long stock position if you thought that the potential for a dramatic move lower was greater than a dramatic move higher. This is a perfect structure for longs who are not 100% that the story is over, and want to participate in some further upside, but could not stomach a massive sell off.
Event: JPM reports its Q1 earnings before the open on Friday Apr 12th. The options are pricing in about a 2.5% move based on the weekly straddle, relative to 2.75% avg. move over the past 4 and 8 quarters.
Sentiment: Wall Street analysts are bullish on the stock with 33 Buys, 6 Holds and 3 Sells, and an average 12 month price target of around $55. Short interest is negligible, at only 1.1% of float. Option open interest is almost evenly split between calls and puts, while the 1 month average volume has favored calls to puts by a ratio of 1.5 to 1.
Fundamentals / Valuation: The bull case for JPM is based mostly on its cheap valuation and free cash flow. Here’s the summary from GS Research:
Despite recent underperformance in JPM shares post-CCAR (-4% vs. BKX -1%), we believe the long-term thesis remains intact. From a price/earnings perspective, JPM is one of the least expensive banks in our coverage universe despite strong earnings consistency, a high near-term return on equity (15%+ ROTCE), and leading shareholder capital return. While late-cycle banks like BAC that are starting at a more depressed earnings level will likely have stronger EPS growth over the next few years, JPM still trades at a discounted multiple on normalized earnings without the execution risk of achieving consensus EPS growth estimates of 15-25% annually. To that end, we believe investors have a better risk/reward skew paying 7.9x 2015E EPS for JPM which is contingent upon a 7% EPS CAGR vs. paying 8.3x 2015E EPS for BAC which is contingent upon a 25% EPS CAGR. More so, we believe “normalized” earnings growth will be better for JPM as significant investments in growth initiatives over the past few years start to pay dividends.
On the capital return side, despite (1) being asked to “address weakness in capital planning” on the recent CCAR exam, and (2) a buyback announcement that was lower than expectations ($6bn), we do not view either as a read-across for future capital return capacity. Once JPM reaches its fully-phased Basel III target of 9.5%-plus by the end of this year and continues to mitigate risk-weighted assets through 2014, we estimate excess capital generation will equate to 120bp every year. This translates into room for a 3.5% dividend yield on current share price (assuming a 30% payout ratio) and $13bn of buyback capacity every year (7% implied yield).
The bear case is focused on the risk to earnings going forward due to increased regulations (such as the Senate’s recent proposal to force the largest 6 banks, including JPM, to raise significantly more capital), reduced risk-taking (especially after last year’s Whale incident), and a less favorable mortgage banking environment due to already low rates having translated into prior refinancing activities that won’t be repeated.
In the meantime, weakness in European financials has weighed on the financials sector in the last month.
Price Action / Technicals: The stock has found resistance near 50 multiple times in the past 5 years. Here is the 5 year weekly chart:
5 year weekly chart of JPM, Courtesy of Bloomberg
While 50 is obvious resistance, the high from 2012 around 46 is likely near-term support.
Volatility: The 30 day realized vol (in blue) is near 1 year lows, and the 30 day implied vol (in red) is close to where it has been in the past couple times just prior to earnings:
1 year chart of 30 day IV vs. 30 day RV, Courtesy of LiveVolPro
All in all, pricing for volatility seems relatively fair.
My View: In the past 3 years, the banking sector and JPM have had a strong start to the year, and then struggled after the first quarter earnings season. The earnings reports for the first quarter have generally been positive, but the price action after earnings was generally a result of overly optimistic expectations by investors and traders who had exuberantly bid up the sector in the preceding weeks and months. This year’s setup feels similar, but the broader macro environment is more likely to be a catalyst than individual earnings.
No Trade. We look at a number of different names and setups, and the trades you see us do on the site are the select few among that group. In many cases, like in JPM here, our inputs don’t lead to a solid trading conclusion, so we stay away.