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Hello readers, in this article I will describe the most neutral option strategy you might want to use this week, along with its potential return, cash requirements and scenarios that might arise.

I will first look into some consensus EPS forecasts and moves on IBM before presenting the trade ideas.

International Business Machines (IBM) reports on Wednesday, July 28th. The company is expected to report $3.42 EPS vs. $2.78 in the last quarter, a 23% increase. The high EPS forecast by analysts is $3.51, and the lowest forecast is for $3.31 EPS, with 20 analysts recording their estimates.

The company's "surprise" index is at 5.7%, meaning it usually reports 5.7% lower or higher than expected by the analysts who follow the stock.

In the graph below, we have the last four expected and reported EPS for IBM:

Next, we have a table that shows how the share value has behaved the trading day before the earnings announcement, the day of the announcement and the day after it:

IBM

Report date

Date

Price

% move

7/15/2011

$ 172.68

7/18/2011

7/18/2011

$ 172.42

-0.2%

7/19/2011

$ 182.19

5.7%

10/14/2011

$ 188.24

10/17/2011

10/17/2011

$ 184.35

-2.1%

10/18/2011

$ 176.75

-4.1%

1/18/2012

$ 178.06

1/19/2012

1/19/2012

$ 179.07

0.6%

1/20/2012

$ 183.27

2.3%

4/16/2012

$ 184.79

4/17/2012

4/17/2012

$ 184.08

-0.4%

4/18/2012

$ 190.00

Unknown

Expected range with a

5.7% move

$ 173.59

$ 194.57

Average stock move day

after earnings

1.3%

Trade idea for IBM

The trade ideas are option-based, as buying or selling stock is a slow and steady process, and what we are looking for with these trades is maximum ROI with minimum risk.

Reasoning for this trade:

  • I want to place a trade that takes advantage of the heightened volatility
  • I have no bias up or down for this stock
  • I am looking to place the most neutral option strategy possible
  • The strategy I am about to present has worked well for me in the past, especially with low-moving stocks after announcements, and looks very suited for this: an Iron Condor. Take a look at what the trade would look like this Friday:

This is an Iron Condor. What this means is that you sell both a put spread and a call spread.

For this example, we will:

Buy to open the 170 strike price put for July,

Sell to open the 175 strike price put for July,

Sell to open the 195 strike price call for July, and

Buy to open the 200 strike price call for July

This whole transaction would require $500 of cash in your account, but since you receive $67 per contract, the cash you're required to keep in your account comes down to $433 (excluding commissions).

As you can see in the graph above, your break-even points for this trade, which expires this Friday, would be $174.33 and $195.67.

This would require the stock to move more than 5.6% by this Friday for this trade to begin losing money.

This means that, for this trade to be successful, all that has to happen is for the stock to stay between those prices by Friday, and you keep the whole premium.

If history and this stock's steadiness is any guide, IBM shares are very probably going to stay in those price ranges. If that happens, you have a 13.4% ROI in just 2 days.

What we try to avoid is a bad scenario, where the stock moves a lot more than expected, and we find ourselves looking for the right thing to do. You have to plan this before you go into the trade, and if you feel uncomfortable with those strike prices, you can try your own mix, depending on your risk tolerance.

Bad Scenario

Let's say the stock made a bigger move than you expected either way. For example, let's say it goes down to $167.50, and you are at risk of losing your $500 per contract (since the strike prices are $5 away * 100 shares per contract).

You have four options:

  • Take the loss as soon as possible, closing the whole position
  • Wait it out until Friday and hope for a price reversal
  • "Roll" your winning side of the trade down

"Rolling", in this case, consists of closing the winning end of the trade, and then selling to open the spread again with strike prices that are closer to stock's current price. In this example it would be the call side.

You would have to:

Buy to close the 195 strike price calls for July, and

Sell to close the 200 strike price calls for July

The debit you have to pay to close this trade would now be very low, considering how out-of-the-money the calls are.

And then:

Sell to open the 175 strike price calls for July (or August if the premium is too low), and

Buy to open the 180 strike price calls for July (or August)

This is done to collect more credit from the winning side to offset the losses on the put side. Choose your strike prices carefully to stay safe, in case the price reverses up. In this case, I felt if this scenario plays out (IBM going down to $167.50), a move up of more than 4.2% after such a strong move down is unlikely. You can choose other strikes if you feel unsafe with this spread.

  • The fourth option is to "roll" your losing side of the trade up

"Rolling," in this case, consists of buying back the losing side of the trade and selling a put spread again, with strike prices that are farther away from the current stock price. You would have to:

Buy to close the 175 strike price put for July, and

Sell to close the 170 strike price put for July

This is all done at a debit, and since it is your losing position, you would have to pay more than you collected to close it. So to offset the cost a bit, you would then have to choose your strikes to sell the puts again. For this example, I would:

Sell to open 165 strike price put for July, and

Buy to open the 160 strike price put for July

Be very careful with Iron Condors, as they can be devastating if not done correctly, or if you roll too tight, the situation may turn against you. I would strongly recommend you paper trade this first if you have never done Iron Condors before, to get a taste of what you could have earned (or lost).

If you are paper trading and want some experience in rolling your positions, I recommend the following trade, which is much more aggressive, and has a higher chance of forcing you to roll your positions:

Buy to open the 175 strike price put for July,

Sell to open the 180 strike price put for July,

Sell to open the 190 strike price call for July, and

Buy to open the 195 strike price call for July

This would give you $166 per contract, requiring you to keep ($500-$172=$334) $328 in your account.

If this trade is successful, you would have a ROI of 34.4% in just 2 days. This is not recommended for the faint of heart, and I strongly recommend this as a paper trade only, to practice "rolling" Iron Condors.

This is how the trade will look on Friday:

The break-even prices are $178.28 and $191.72, so the stock price would have to stay in that range for your trade to be profitable.

Some levels to watch when selecting strike prices

By looking at this daily chart, we can see how IBM is now down from around the $200 level it was weeks ago, and it will take a huge move to take it there.

The 50 and 200 day moving averages are at around $194, so that will be resistance for now. It also looks like this stock has some support around the $180 level. We will see if any of those hold.

Remember, paper trade first, especially for this last trade, which is much more aggressive. Feel free to use the comment section below to ask questions if something was not clear or to post your own trades.

Source: Trading IBM Earnings: How To Earn 13% ROI By Friday

Additional disclosure: I will initiate the first trade option idea in less than 24 hours.