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How to Use Expectations to Prosper With Earnings Announcements
The earnings season started just last week. In my last Idea of the Week I recommended buying a straddle on JPMorgan (JPM), the first big company to announce this time around. We made that trade in an actual portfolio for Terry’s Tips subscribers and closed it out for a 15%+ gain after commissions.
I also suggested an options strategy for JPM in a Seeking Alpha article - How To Play The JPMorgan Earnings Announcement. In another Terry’s Tips portfolio we placed calendar spreads as outlined in this article and closed them out for a gain of 15% after commissions even though the stock fell a little after the announcement while we were betting that it would go higher.
A wonderful thing about options is that you can be wrong and still make profits as we did last week in our JPM trades. Terry’s Tips subscribers who followed both portfolios made over 30% last week, more than most people make in an entire year of stock market investing.
This week I wrote another Seeking Alpha article which checks out seven big companies which announce this week – How To Play The First Week Of The April Earnings Season.
The major message of this article is that the price of the stock after the announcement is more dependent on pre-announcement market expectations than the actual numbers that the company releases. If expectations are too high, the stock will fall no matter how much the company beats the analysts’ projections.
Of the seven companies reviewed, SanDisk (SNDK) seemed to have the highest level of expectations. Whisper numbers were 18.6% higher than analyst projections, the stock had shot up over 10% to a new high over the last week, and had moved 5% higher in the last week alone. We believe that it is highly likely that some investors will “sell on the news” no matter how good it is, and the stock will either stay flat or fall after the announcement.
With the stock trading about $57.70, I am buying May 75.5 puts and selling April 55 puts. Implied volatility (IV) of the May options is 37 while the April options carry an IV of 70, nearly double the May number (this means you are buying “cheap” and selling “expensive” options). Each diagonal spread would cost $163 to place at the natural option prices at the close on Friday.
Here is the risk profile graph for these spreads if you bought 20 of them, investing about $3400 after commissions (of course, you could buy fewer, or more, if you wished):
This graph assumes that after the announcement, implied volatility (IV) of the May options will fall from its current 37 to 30 which is more likely in a non-announcement time period. The graph shows that when you close the positions on Friday, April 19th, a double-digit gain could be made if the stock holds steady, and could nearly double your investment if it fell about $2 ½ after the announcement. A profit would result no matter how far the stock might fall in value.
We think the stock is likely to fall after the announcement because expectations are so unusually high. If it moves higher, however, a loss could very well result. Even in the world of options, there is no free lunch. You need to take a risk. We like our chances here.
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Any questions? I would love to hear from you by email (terry@terrystips.com), or if you would like to talk to our guy Seth, give him a jingle at 800-803-4595 and either ask him your question(s) or give him your thoughts.
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I look forward to having you on board, and to prospering with you.
Terry
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