Google Options Underestimated The Risk, Again

| About: Alphabet Inc. (GOOG)

Well, Google (NASDAQ:GOOG) did it again. Earnings disappointed and the stock was down 8.4% on Friday.

In one of my previous articles, I demonstrated that buying a straddle (the At-The-Money (ATM) call and the ATM put with the same expiration) a day before earnings and selling it the next day would work pretty well for Google, resulting in an average return of 35.37%.

This cycle confirmed the trend. Google closed at $639.57 Thursday before the earnings. The $640 straddle could be purchased at $35.50. The straddle could have been sold at the close Friday at $54.00. That's a 52% gain. The following table contains the data for the last eleven cycles, including the current one.

So what does this data tell us?

The conclusion is clear: On average, Google options tend to be underpriced before earnings.

How would you play it? The simplest way is just buying the straddle. However, the straddle would require a 5.5% move just to break even. And in some cases, if the stock moves just 2-3%, it would lose 50-60%, as you can see in the table. Of course, in two cases the straddle produced a ~150% gain, but that required the stock to move 11-13%. This will not happen very often.

How about a strangle? A strangle is similar to a straddle, but involves buying Out-Of-The-Money (OTM) strikes. Depending on the strikes, the results might vary from 50% to 150%. But strangles are also much more risky. If the stock moves less than expected, the loss of 100% is very likely.

An alternative way to structure the trade is buying an OTM strangle and selling a further OTM strangle, creating a Reverse Iron Condor. With the stock trading around $639, you could do the following trade:

  • Sell GOOG January 2012 620 put

  • Buy GOOG January 2012 630 put

  • Buy GOOG January 2012 650 call

  • Sell GOOG January 2012 660 call

This trade could be done for about $8.40. With the stock trading at $590, the call spread would expire worthless but the put spread will have the full $10 value, producing a 19% gain. The breakeven points are $658.40 and $621.60, which would require a 2.8% move.

If you wanted to be more aggressive, you could move the strikes 10 points further OTM:

  • Sell GOOG January 2012 610 put

  • Buy GOOG January 2012 620 put

  • Buy GOOG January 2012 660 call

  • Sell GOOG January 2012 670 call

In this case, you would pay around $6.50 and the potential profit would be 54%. But it would require 4% move to break even and 4.5% move to realize the full gain.

Of course the risk is that the stock moves less than 2-3% and the trade loses most of the value. It didn't happen in the last three years but it doesn't mean it cannot happen in the future. If this is the risk you are ready to accept, then this might be a reasonable trade to make and keep for earnings.

As my regular readers know, I prefer not holding those trades through earnings. I played Google two times this cycle using similar trades (you can see details here). Both trades have been profitable, with gains of 14% and 3%. If the stock makes a bigger move before earnings, the gains can be higher. I just think that in general, selling before earnings will produce more predictable and consistent results with less risk.

The bottom line: Risk/reward and probability of success are highly correlated. You cannot have both. You need to choose between higher potential profit but lower probability and lower potential profit but higher probability. It should be obvious to most traders, but even the "experts" on CNBC miss it many times. That said, Google remains one of the few stocks I might consider keeping for earnings.

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

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