Whatever You Do, Don't Do This Before Apple's Earnings

Jan.15.12 | About: Apple Inc. (AAPL)

In my previous Apple (NASDAQ:AAPL) article, I shared some thoughts about the company, including price target predictions (most of them have been wrong) and some ways to trade Apple options.

As a reminder, I suggested as a sample trade a February Iron Condor with strikes located ~10% from the current stock price. This is a bet that Apple will not move more than 10% in either direction in the next 5 weeks. As a hedge, you could trade a Reverse Iron Condor using weekly options.

If you want to bet on the upside, you can check a directional idea that I presented in my "Options Plays For Predicting Where Google, Apple Won't Be In 3 Months" article on December 13, 2011. The Apple trade that I mentioned in the article would be up 36% by now while the stock was up 9% during the same period. This is the power of options.

I got many comments suggesting that you can simply buy Apple call options ahead of the company earnings on Tuesday, January 24, 2012. I decided to check how this trade would perform in the last eight cycles. The following table presents a one day return of the ATM (At The Money) call option purchased at the close before the earnings day and sold at the close the next day. If the stock was between strikes, the next OTM (Out of The Money) option was chosen.

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Of course purchasing puts would perform even worse:

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How about buying both?

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The explanation for those numbers is simple. Over time, the options tend to overprice the potential post-earnings move. Those options experience huge volatility drop the day after the earnings are announced. In most cases, this drop erases most of the gains, even if the stock had a substantial move.

Jeff Augen, a successful options trader and author of six books, agrees:

There are many examples of extraordinary large earnings-related price spikes that are not reflected in pre-announcement prices. Unfortunately, there is no reliable method for predicting such an event. The opposite case is much more common - pre-earnings option prices tend to exaggerate the risk by anticipating the largest possible spike.

By the way, Google (NASDAQ:GOOG) is one of the exceptions, as I showed in my article "Should You Buy Google Straddle Ahead Of Earnings?". GOOG one day straddle would perform very well, resulting a healthy 35.4% average return.

"Trying to predict the future is like driving down a country road at night with no headlights on and looking out the back window." - Peter Drucker

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.