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Baidu (NASDAQ:BIDU) reports earnings on Thursday, February 16, 2012, after the market close.

There are many ways to play earnings. Some people would bet on the direction of the stock movement after the announcement and buy or short the stock. Others will buy call or put options. My opinion is that predicting the market reaction to earnings is extremely difficult task. In case of Baidu, the options expiration is the next day after the announcement, so if you are wrong, you are likely to experience a 100% loss.

The rest of this article is devoted to non-directional strategies to play the event.

Trade #1: Buying a straddle and selling after the announcement

The following table summarizes the return of the ATM straddle purchased at the close of the earnings date (before the announcement) and sold at the close of the day following the earnings report.

For those less familiar with options, a straddle is buying the At-The-Money (ATM) call and the ATM put with the same expiration.

As we can see, this strategy would not be a big success, resulting an average loss of 14.36%, with some trades losing as much as 65-70%. This should not come as a surprise to my regular readers. I performed a similar analysis for few other stocks. Apple (NASDAQ:AAPL) one day straddle produced an average loss of 28.00%. Playing Amazon (NASDAQ:AMZN) the same way would produce an average loss of 17.99%. Seems like Apple and Amazon options are overpriced (on average) before earnings. I believe that this is the case for most stocks. Options simply tend to overestimate the potential risk.

Of course there are always exceptions. Google (NASDAQ:GOOG) and Netflix (NASDAQ:NFLX) straddles would actually produce very impressive gains on average, but in some cycles they would still lose 50-60%. You can see the full analysis here and here.

If you think that the stock will move more than 5-6% this time, this might be a good choice.

Trade #2: Buying a Reverse Iron Condor and selling after the announcement

A Reverse Iron Condor involves buying an Out-of-The-Money (OTM) strangle and selling a further OTM strangle. With the stock trading around $131, you can execute the following trade:

  • Sell BIDU February 2012 125.0 put
  • Buy BIDU February 2012 130.0 put
  • Buy BIDU February 2012 135.0 call
  • Sell BIDU February 2012 140.0 call

The trade can be executed for $3.60 debit. The maximum gain is $1.40 or 38.8%. It is realized if the stock closes below $125 or above $140 the day after the announcement. That's 6% move. Since the stock moved less than 6% in the last few cycles, this seems like a very risky trade. It might be a good idea to tighten the strikes (essentially turning the trade into a butterfly), but the trade will still require about 4% move.

The next three trades are volatility plays. The idea is to take advantage of the rising IV (Implied Volatility) of the options before the earnings. I described the general concept here. The trade would be purchased a few days before earnings and sold just before earnings are announced (or as soon as the trade produces a sufficient profit).

Trade #3: Buying a strangle and selling before the announcement

  • Buy BIDU February 2012 130.0 put
  • Buy BIDU February 2012 135.0 call

The trade can be executed for $9.00. This is very aggressive and risky play. The negative theta is 5.5% per day and it will accelerate as we get closer to expiration. We need a big jump in IV and/or a big stock movement to offset the theta. If it doesn't happen, the trade could easily lose 25-30%. However, if the stock makes a decent move, the gains can be substantial. This trade is about high risk high reward.

Trade #4: Buying a straddle and selling before the announcement

  • Buy BIDU February 2012 130.0 put
  • Buy BIDU February 2012 130.0 call

Or

  • Buy BIDU February 2012 135.0 put
  • Buy BIDU February 2012 135.0 call

The trade can be executed for $11.20. Since the stock is between the strikes now, you might want to wait till it moves close to one of the strikes in order to be delta neutral. The negative theta is 4.2%, still fairly large. This trade is slightly less aggressive than the previous one, but we still need a big jump in IV and/or a big stock movement to offset the theta.

Trade #5: Buying a Reverse Iron Condor and selling before the announcement

  • Sell BIDU February 2012 120.0 put
  • Buy BIDU February 2012 125.0 put
  • Buy BIDU February 2012 135.0 call
  • Sell BIDU February 2012 140.0 call

This is actually my favorite trade and the one I will be placing for my personal account. The trade can be placed for $2.90. The negative theta is 2.7% which is more acceptable. It will still benefit from IV increase and/or the stock movement, but the risk is lower due to smaller negative theta. Since the earnings are very close to expiration, I'm planning to place the trade just few days before the earnings date to reduce the theta exposure.

The main and only risk of those trades is the negative theta (time decay). The expectation is that an increase in IV will offset the theta, but it doesn't always happen. If the stock moves, it will help. In any case, you can control your loss since theta damage is gradual. In general, it is very unusual to lose more than 10-15% on those trades, except for the most aggressive ones.

Good luck. Let me know if you have any questions in comments below. The prices might be different when you place the trade so adjust the strikes accordingly. If you decide to place those trades, please make sure you understand what you are doing.

Source: 5 Ways To Play Baidu Earnings