By: John J. Critchley, Jr.
IBM (IBM) kicks off earnings week as the technology juggernaut reports after the bell Monday. Analysts are officially looking for $ 3.20 a share in earnings. The unofficial number that is ‘whispered’ on the street is closer to $3.30 a share.
The price movement of IBM has left some to ponder if Big Blue’s stock price has gotten ahead of itself. Analysts apparently don’t think so. On Friday, IBM reached an all-time high after two street analysts, Collins Stewart and Macquarie both came out with bullish reports that pegged an IBM price target at $210 a share.
If we look at IBM’s past history with earnings reports there is reason to believe that Mondays release will be a bullish one. The technology blue chip (pun intended) has not often missed an estimate. One would have to go all the way back to April 2005 to find the last time the company fell short. So, beating this time around on the headline numbers probably won’t be an issue, especially with rather damped down expectations.
However, more importantly than beating estimates, of course, is how the underlying reacts after reporting. In this area, IBM also has a stellar record as well. The shares have gone higher in the following week following the past five reports, with an average weekly gain of around 6%.
What’s more, IBM's options appear to be quite reasonably priced.
What makes playing IBM’s earnings quite tricky from a long or short only perspective is that the company has a history of nearly always beating the street estimates and nearly always rising post-earnings. Okay, so let’s get long. Not so fast. What is so wrong with that? Nothing, except that the company is sitting near record highs and even a minor revenue shortfall or lowered revenue/earnings forecast and the stock could collapse. So let’s play the short side, what is so wrong with that? Nothing, except the aforementioned track record of multi-year IBM earnings ‘beats’.
Confused on what to do with the earnings? Long or short? How about playing both ways?
With IBM trading near all time highs, the implied volatility of the options is quite a distance from its 52 week highs. The 30 day implied volatility is trading around 27.61%, significantly less from the 52 week implied volatility high of 41.16% hit just a few weeks ago.
Let’s take advantage of these reasonable implied volatilities to initiate a position that takes advantage of any post-earnings move in the underlying. If you believe this scenario may play out, let’s buy a straddle.
This is not a specific trade recommendation, but a trade analysis.
Trade idea–A Long Options Volatility/Premium Play
To find a reasonable pure earnings option play, one could go out to the Oct ’11 options, which present some interesting short term value.
a) Buy Oct ‘11 190 straddle for $ 7.40. The implied volatility of this straddle is seemingly quite high at approximately 55% IV (Implied Volatility). This IV reading is, however misleading because the most important determinant of an options real value as it gets closer to expiration is the premium only, not the actual IV% reading. The premium over parity (POP) number of $7.40 is what is really paramount.
Net debit: $7.40
Why the October 190 line? You are buying the At-the-Money straddle for $7.40. The breakevens for this straddle in the underlying are $197.40 and $182.60 respectively. These breakeven points represent a 3.9% move in the underlying. This percentage move does not appear to be unreasonable especially considering that you are buying ‘event premium’ plus the heightened volatility of the market as whole. Remember, the average weekly gain for IBM post-earnings is around 6% on the upside. On the downside, if there is ever any miss in the numbers the stock could certainly fall quite precipitously.
Risk: The earnings report does not cause the expected movement in the underlying. Be forewarned. You may lose the entire premium. This play is for speculative monies only.
Notes: Prices quoted where the prices at time of submission and do not reflect current market prices.