So you want to know if you should buy a Google (GOOG) straddle ahead of their earnings report on Thursday, January 19, 2012? I must disappoint you: I don't have a definite answer. Every investor should make that decision based on his personal style and risk appetite. However, since you are already reading the article, keep reading - you might learn some interesting facts.
The trigger for this article was an excellent article by Mark Abssy. For those less familiar with options, a straddle is buying the At-The-Money (ATM) call and the ATM put with the same expiration. A strangle is similar to a straddle, but involves buying Out-Of-The-Money (OTM) strikes. In his article, Mark is analyzing the results of executing those trades before the last Google earnings in October 2011. The result was a bit disappointing. Despite Google's healthy beat, the trades resulted much less than "expected" returns. Mark provides an excellent explanation:
"When a company reaches some decision point or announcement event, it is creating a certain amount of uncertainty. The greater the uncertainty there is, the greater the opportunity for movement in the stock price. The market generally expresses uncertainty the only way it knows how, through volatility. Once that uncertainty is removed, volatility generally goes with it. When you went through the steps of researching and modeling this trade, you looked at historical post-earnings announcement price moves but did not research historical implied volatility changes for these same periods. It turns out that over the same 25 periods, you observe that the average implied volatility for GOOG changes from 42.43 on the day of earnings to 33.50 on the day after the announcement, a 21% decline! You got caught in a "vol crush!"
This is in line with my own research which indicates that on average, options are overpriced before the earnings. My favorite way is buying a strangle or a straddle few days before earnings and selling it just before earnings are announced (or as soon as the trade produces a sufficient profit). The idea is to take advantage of the rising IV (Implied Volatility) of the options before the earnings. I described the general concept in my article Exploiting Earnings Associated Rising Volatility. However, after reading Mark's article, I decided to check how buying a straddle and holding it through earnings would perform. The following table summarizes the return of the ATM straddle purchased at the close of the earnings date and sold at the close of the day following the earnings report.
I must say that the results surprised me. The average return for this strategy in the last ten cycles would be a healthy 35%. Does it change my view?
The answer is no, and I'll explain.
First, the results have been heavily impacted by just two cycles (July 2011 and October 2010). If you remove those two cycles, the return is still positive but only 6%. The results assume selling at the close which is not always possible, so practical results would be probably slightly lower.
Second, I'm still convinced that Google is an exception and not a rule. It would be interesting to check the performance of other popular stocks like Apple (AAPL), Netflix (NFLX), Amazon (AMZN) or Baidu (BIDU).
Third and the most important, this strategy lacks consistency and predictability. You can get over 100% return in one cycle and lose 50-70% in the next one. The strategy of selling before the announcement might have lower returns, but I would take a consistent and predictable 10-15% return per trade with both hands.
For Google, I'm usually using the Reverse iron Condor strategy (selling further OTM strangle against the purchased strangle). I already played the stock in this cycle and closed the trade for 14% gain. I re-entered it with different strikes.
With the stock trading around $625, the trade is:
- Sell GOOG January 2012 590 put
- Buy GOOG January 2012 600 put
- Buy GOOG January 2012 650 call
- Sell GOOG January 2012 660 call
Check my other articles to see how I'm trading this strategy. You can click on the "Follow" button if you want to get notifications about my next articles.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.