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 an extremely difficult task. In case of Google, 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. All trades refer to weekly options expiring on April 14, 2012. The stock is trading around $641.30.
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.
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For those less familiar with options, a straddle is buying the At-The-Money (ATM) call and the ATM put with the same expiration.
If history repeats itself, purchasing a straddle just before earnings and selling it the next day would be a good bet. However, it is still a risky bet - in some cases, you would lose 50-60%.
Personally, I'm not a fan of holding those trades through earnings, as I explained in one of my previous articles. I think that in general, options tend to be overpriced before earnings. I prefer to buy few days before earnings and sell before the announcement, as I explained in my "Exploiting Earnings Associated Rising Volatility" article. The idea is to take advantage of the rising IV (Implied Volatility) of the options before the earnings. 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.
I still think that this is true for most companies and Google is one the exceptions. I performed a similar analysis for few other stocks. Apple (AAPL) one day straddle produced an average loss of 28.00%. Playing Amazon (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. Netflix (NFLX) straddles would produce very impressive gains on average, but in some cycles they would still lose 50-60%.
If you think that the stock will move more than 6-7% 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 $640, you can execute the following trade:
- Sell GOOG April Week2 2012 630.0 put
- Buy GOOG April Week2 2012 635.0 put
- Buy GOOG April Week2 2012 645.0 call
- Sell GOOG April Week2 2012 650.0 call
The maximum gain is realized if the stock closes below $630 or above $650 the day after the announcement. That's 1.5% move. There is a fairly good chance that the stock will move more than 1.5% post-earnings.
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 GOOG April Week2 2012 630.0 put
- Buy GOOG April Week2 2012 650.0 call
This is very aggressive and risky play. The negative theta is fairly high 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 GOOG April Week2 2012 640.0 put
- Buy GOOG April Week2 2012 640.0 call
The negative theta is still fairly large but less than in the strangle. 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 GOOG April Week2 2012 610.0 put
- Buy GOOG April Week2 2012 615.0 put
- Buy GOOG April Week2 2012 665.0 call
- Sell GOOG April Week2 2012 670.0 call
This is actually my favorite trade and the one I will be placing for my personal account. The negative theta 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 alternative is trading the monthly April options. They will have less negative theta, but the IV increase will be less as well.
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.
Disclosure: I will be initiating one of the mentioned trades within the next 72 hours.