11/14/2013 THURS

Earnings Volatility: Friend or Foe?

      When a company has an earning conference scheduled, many times there is speculation not only in regards to the accuracy of the projected Earnings Per Share (EPS), but to several other factors as well. These include, but are not limited to sales and revenue streams, products in the pipe line, cash on hand, management changes, possible future stock or bond offerings, etc. The uncertainty may cause volatility in the shares themselves, but the diamond in the rough is actually the temporary parabolic increase in the exchange listed options on the underlying shares. Traders tend to stay on the side lines going into the days leading up to the earnings conferences. Call buyers swap out shares of stock for call options so they may participate in a rise should the shares move higher and limit the potential should the shares trade lower, forcing the call options to trade, in many cases, a drastically expanded volatility. Additionally, put buyers force the options higher as they try and protect their positions.

      From a traders perspective the opportunity to capitalize on the potential volatility allows them to capitalize with limited risk via Verticals, Butterfly’s, and Diagonal Spreads. A Long Vertical Spread is simply a long call at a lower strike and a short call at a higher strike or a long put at a higher strike and a short put at a lower strike, normally in the front two months where premium is most sensitive and susceptible to Theta (time decay), especially if the earning are in the last week prior to expiration. The Long Butterfly is similar but it is achieved by buying a long vertical and selling a short vertical with a common short strike. The Long Diagonal is achieved by selling a front month option and buying a back month option of the same type, put or call, on different strikes. The trick is to devise a way to use options to benefit from a potentially large swing either up or down to your advantage.

      The first step is to identify and qualify a particular stock that by looking at past performance of the stocks movement going into earnings and finding those stocks that have the earnings calls closest to expiration. Certain stocks like Intuit Surgical Inc. (ISRG), Priceline.com Inc. (PCLN), and Google (GOOG) are prime examples of stocks that have the potential for large moves and have earning calls close enough to expiration to qualify taking a look at.

      The second step is to take a look through back testing at what volatility has done at those points in time, looking for dramatic increases in front and second month volatility a few days prior to the earnings call. In ISRG front month volatility is usually around 30% +/- 3% with earnings scheduled a couple days before expiration and can move 50 or more points either way, makes the stock a great candidate to look at. Patience is key as well as identifying several stocks that fit the parameters to justify the placing the trades. Normally the volatility doubles and in some cases is more extreme than that, which is what you need to look for. For this very reason it is essential to have several stocks to watch closely due to the fact that they may not all present an equal opportunity to place a trade, remembering the goal is to take advantage of the temporary rise in volatility

The full article can be viewed at tradersexclesive.com

*Disclaimer: This is not a recommendation. All trading entails risk. Anyone employing any strategies and having limited knowledge of options trading should consult with a FNRA licensed professional.