The Long Cases On Apollo Group and Mosaic Going Into Earnings

One of the trading skills that I have developed over the years is playing earnings catalysts. One way to play earnings catalysts is to straddle or strangle historically volatile stocks with options going into their earnings announcement. By buying calls and puts, you are going long volatility.

The best strangle and straddle option trades are trades involving what are called "binary catalyst events". These events have a high probability of a large price change either up or down. It is also important to make sure the options are liquid enough to be able to speculate on. It saves the disappointment of being right but unable to profit from your correct analysis of the situation. There are a number of events that are considered binary catalysts such as earnings announcements or revisions, FDA drug approvals, drug trial results, mergers or acquisitions, and large contract orders or changes.

This week I will be watching Apollo Group (APOL) and Mosaic's (MOS) earnings on Jan. 8th and 9th, respectively. I expect both to beat earnings estimates and have started to watch options activity, price changes and technicals very closely.

APOL has shown historic volatility during previous earnings announcements so volatility is a high probability. MOS has shown volatility in the previous four months with large price ranges and volatility after earnings although the earnings gaps are not as large as APOL.

I have a directional bias of being long going into both events but will hedge accordingly with puts just in case they disappoint. If they do disappoint or lower guidance, which is a lower probability, their price will drop and gap down once the market opens for stock.

I expect to strangle both events rather than straddle them, which calls for buying OTM calls and OTM puts with a long bias overweight on the calls vs. the puts. I like to use a dollar weighted ($300 on the calls and $100 on the puts for a 3:1 ratio) hedge - that way I can effectively hedge my risk exposure, effectively implement my strategy and adhere to my formulated risk/reward ratio. In the future, I will bring together the concepts of breaking down earnings and drug catalysts into three separate plays with different objectives ( i.e. pre earnings/drug IV plays, earnings/drug straddle and strangle catalyst event plays and Post IV-implosion Gap Trade plays).

Directly playing the earnings catalyst is risky and the max loss on a strangle or straddle is the amount of total premium of both calls and puts. A loss can be expected if the stock is not volatile after the earnings announcement and an IV implosion occurs in the option prices because the catalyst is over. That is why I love using the Post IV Implosion Trade strategy after the facts and numbers are known, so you can analyze the technicals and the news with less risk exposure. Another important factor is correctly gauging market sentiment and stock sentiment in strategizing an earnings play and which strategy to employ. The Case for APOL

As the economy has weakened, unemployment has risen. Those out of work usually must obtain new skills and knowledge in order to facilitate a new career in their chosen fields. Healthcare occupations have risen while finance jobs have substantially weakened. These larger macro changes in our economy require this new workforce to adapt to the changing times, which should be a boon to education corporations profiting from teaching new skills to this changing workforce trend.

APOL who owns the University of Phoenix Institute for Professional Development as well as other schools could benefit greatly from this re-education trend as well as their offering of 'easy' schooling using new technological developments with their online programs and degrees. Teaching has gone virtual and no longer has the physical barriers it once did for specialized education.

APOL is expected to bring in earnings of .73 a share on Tuesday night and revenues of $750.9 million. They did not issue earnings guidance last time, and it is unknown if they will issue it this time around. They have beaten earnings twice in the last year, missed once and met their most recent earnings estimates in October 2007. Bank of America has a $90 price target on the shares but earnings estimates have been lowered overall in the past 90 days from .75 to .73 for the current quarter and .53 to .51 for next quarter. Don't read too much into this, because the numbers may have been slightly skewed by one recent analyst's comments and changes.

The less publicized news with APOL is their share buyback program which was increased by another approximately 7 million shares, or $500 million, after repurchasing 7 million shares in Q4. Because APOL is accounting for the buyback over time, the first 7 million share buyback was not yet fully discounted in the per share calculation last quarter and the new share buyback now is added fuel in the longer term as it became accounted for in their earnings over the next year in fiscal 2008. This should have a positive effect on the per share profits and could continually do so as it is accrued on a weighted average over time.

I am leaning towards a long bias on this stock but could move into an even strangle depending on price volume action over the next couple days with my market sentiment analysis. It does have a high probability of volatility and that's what I really like. I will be scoping out the OTM calls and puts going into the event and a 10+ point reaction to the announcement. The Case for MOS

MOS has been on fire the past four months going from $40 to nearly $100 recently. When looking at the growth estimates one should not be surprised. Current quarter growth estimates of 380% for the current quarter and next quarter's prediction of 1,620% YoY growth is amazing and is correlated to higher and growing fertilizer prices on the world market. There seems to be no end to the climbing of those fertilizer prices as supply constraints keep prices higher with strong support. Estimates for MOS are calling for .72 a share this quarter and $2.1 billion in revenues.

I expect MOS to blow out estimates to the upside and raise guidance due to expected higher demand and prices for fertilizer for at least the first half of 2008 according to analysts and stable prices through the next couple of years. There are serious global supply constraints and until global supplies can affect prices, this bull market should continue. Earnings estimates have increased substantially over the past 90 days with next quarter estimates going from .67 to .86, current year estimates going from $2.80 to $3.48, and next year estimates going from $3.26 to $5.12!

The technicals say it is priced for perfection and there is no room for error with the stock up at $95.41. I expect the stock to be volatile and could move $10+ in either direction after the announcement. It would seem to me that there is a higher probability of price volatility than a price flatline. I am leaning towards a long bias going into the event but hedged with OTM puts with my overweight OTM calls.

The Chameleon

In closing I want to say that this market has been in a fluid situation and pricing in news as it goes so market predictions are very difficult as well as trading. There is no way on gaming the news and expecting it to adhere to your positions, you must adhere to the market. It is important to be neither bullish nor bearish and although I am always optimistic and positive (naturally a bull), I NEVER argue with the market! I always try to adapt to changing market conditions and as news comes in and new market technicals are shown, you must change and UPDATE your own analysis and positions. Be a chameleon, open to new and opportunistic long trades and short trades.

Risk management will separate the weak from the strong so hedging and asset allocation will be key and it is of the utmost importance to be patient and level headed. We are in oversold conditions but until the market finds real strong support, buying falling knives has a lower probability of success than shorting cycle tops and rallies, especially in the weakest names and sectors. I am taking things day by day as this is a fluid situation.

Comments

[Love toshort]

A really solid article. I agree with you on APOL, and will be long the stock heading into earnings. MOS, although you may be right with your long bias, there is really no room for error with the stock having run up so much, and so the risk/reward seems unfavorable. I will likely sit on the sidelines for this one. Again, great in-depth options analysis.

[HarMegiddo]

nice article, i picked it up to read what you said about MOS. i was already long MOS but then i read what you had to say about APOL and i remembered how they act after every earnings. well, i played APOL to the long side and it looks to be turning out OK.
Go Phoenicians!! haha.

[Love toshort]

Both MOS and APOL are up huge this morning, great call on both plays. Cheers

[HarMegiddo]

i sold both right at the open. i made a nice gain on each. what about that action on MOS though? open near $93, then drop to $80 by noontime only to close at $89, what the heck!?