Option markets live for volatility. Approaching events where the outcome is uncertain, option prices increase in anticipation of the unknown. At times that increase is unwarranted because the news will fail to drive prices widely. Other moments, the unknown sparks wide swings that allow for profits.
Research in Motion (RIMM) reports earnings after the market closes on Thursday afternoon. As a favorite of the momentum crowd, RIMM is subject to large price swings.
When approaching an earnings-driven option trade, there are two factors to consider. First, how much will prices move? If the option market's expectations are very different from yours you can create a trade that makes money regardless of which direction prices move.
Looking at RIMM, the option market is expecting a price move of 12%. Over the past five option announcements, RIMM has moved an average of 16%. Typically, this would encourage me to buy a straddle and await a dramatic move, but when you consider that three of the past five post-earnings moves would have resulted in this trade losing money, I am not encouraged.
Ignoring the size of the move, we now focus on the second factor-the direction of the move. On this item I am more encouraged. Over the past five earnings announcements, RIMM has shown a repeatable pattern. Usually, the direction of the price move is dependent on whether the company exceeds its earnings estimate or not. RIMM violates this rule. Instead, the main driver of where prices go after earnings announcements is where they have been before the reporting date. With the exception of the 4th quarter of 2009, the trend of the stock before the announcement was quickly reversed after earnings were announced.
From an option trader's perspective, this is a key data point. As the stock moves higher, more people become bullish. This encourages them to buy call options instead of puts. As the call orders increase, puts decrease in value and allow those who are bearish to buy their position more cheaply. With RIMM 18% higher over the past three weeks, this is what we are witnessing.
Knowing that puts are becoming cheaper as the public becomes more bullish and that RIMM changes direction post-earnings, I see an excellent opportunity to speculate on the stock declining.
Focusing on the October 75 put (RFY+VT) we can speculate on a 12% move lower for the minimal cost of $1.5. By allocating a small percentage of the portfolio to this trade, we put a minimal amount of our capital at risk, but stand to reap large rewards if proven correct. In search of large upside with small downside, I recommend buying a 0.5% position in RFY+VT as this week's option trade.