Conservative Options Play For Next Week's Cisco Earnings Report

| About: Cisco Systems, (CSCO)

Cisco (NASDAQ:CSCO) reports earnings on Wednesday, May 9, 2012, after the market close.

You could buy calls or puts if you think you can predict the market reaction to the earnings. You can buy both (a straddle) and hold through earnings if you think that the stock is going to make a big move but you don't want to bet on a direction of that move.

I personally prefer a different path, as I explained in one of my previous articles. I prefer to buy a 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 a 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.

The strategy performed well so far this year, despite a low IV environment. I'm not looking for home runs here (although I had few when IV spiked), but consistent 10-15% gains with relatively low risk. You can see the 2012 performance here. The model portfolio is up 20% YTD (cash adjusted, with 10% allocation per trade). The ROI is 30% based on the maximum capital on risk.

Let's check Cisco's post-earnings moves in the last eight cycles.

As we can see, the stock had some wild moves, and we can expect a decent rise in the IV before the earnings.

Let's examine the volatility chart.

Can you see those spikes few days before the earnings and then the collapse the day after? To take advantage of this spike, I'm going to place the following trade using the weekly options expiring a few days after the announcement:

  • Buy CSCO May Week2 20 put
  • Buy CSCO May Week2 20 call

The main idea behind the trade is "renting the straddle" before the earnings. An increase in IV should help to neutralize the negative theta and keep the floor under the straddle price. As we know, earnings are 50/50. This is a trade for those who don't want to bet on the direction of the stock and don't want to hold through earnings.

The main and only risk of the trade 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. It is very unusual to lose more than 10-15% on those trades.

Instead of weeklies, you can choose a more distant expiration to reduce the effect of the negative theta. However, the IV increase for the distant expiration will be less as well. The IV is the most inflated for the options with closest expiration.

Please trade responsibly. Invest only what you can afford to lose. If the stock moves before earnings and you decide to execute one of those trades, please adjust the strikes accordingly.

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

Additional disclosure: I will be initiating the trade few days before earnings