In less than two weeks (October 12, 2012), Google (NASDAQ:GOOG) will announce earnings for the quarter. This is the time when option prices - implied volatility (IV) - gets a little crazy. The October options carry an IV of about 35, jacked up because the stock often makes a big move after the announcement.
The November options carry an IV of about 30 which is also higher than a "normal" time when an earnings announcement is not imminent. However, the difference in IV between the November options and the October options gives the buyer of calendar spreads a significant implied volatility advantage. You are buying "cheap" options compared to the "expensive" options you are selling.
There is a huge contrast between the situation in GOOG compared to the option prices of Apple (NASDAQ:AAPL). Apple announces earnings (including 9 days of selling the iPhone 5 - a big uncertainty) on October 15th, also just a few days before the October options expire. An IV advantage does not exist in the AAPL options, however. In fact, the November options carry an IV of 36 compared to only 33 for the October options. This results in an IV disadvantage for AAPL compared to a significant IV advantage for GOOG calendar spreads.
This does not mean that you can't make money with AAPL calendar spreads - it only means that the GOOG calendar spreads enjoy extremely favorable odds at this time.
At Friday's closing prices for GOOG options, an at-the-money calendar spread (755 strike), buying November and selling October options, would cost you about $6.65 ($665 plus commissions per spread) if you used puts or $6.90 ($690 plus commissions per spread) if you used calls.
I prefer to buy put calendar spreads at strikes below the stock price and call calendars at strikes above the stock price because the bid-ask spreads are usually greater for in-the-money options than for out-of-the-money options. When it is time to trade out of (or roll over the short sides to future weeks or months), better prices are generally available when you are trading out-of-the-money options. For the at-the-money spreads, I select the least expensive alternative between puts and calls.
Although it doesn't make much sense from an intuitive standpoint, when you are trading calendar spreads, it doesn't make any difference whether you use puts or calls - the risk/reward numbers are essentially identical. The strike price compared to the stock price is the key number which governs the profit or loss from the spread when the short side expires (the closer they are together, the more profitable the spread).
Another important determinate of the profit or loss on a calendar spread is the IV of the long side when the short side expires. It is important to figure out in advance what that IV might be at that time. Otherwise, you could buy a spread with a totally unrealistic expectation of potential gains.
For example, with GOOG trading about $755, the at-the-money put or call with three weeks of remaining life is selling a little over $24. If you bought the November - October 775 spread for $6.65 and when the October option expired, the stock was trading at exactly $775, the October option would be worthless and the November option would have 28 days of remaining life. If you didn't consider IV, you would assume that this option would be worth at least $24, probably more because it had a week more of remaining life than the current at-the-money option.
You would be quite wrong in this assumption. I went back to check out what GOOG options were trading at on August 24, 2012 when the stock was selling at $680. At that time, IV was about 20 (compared to today's 35), and the at-the-money option with 28 days of remaining life was trading at $15.25, well below when the current ($24) at-the-money option with 20 days of remaining life.
Here are the numbers of what you would pay for GOOG calendar spreads today compared to what those spreads can be expected to be worth depending on how far from the stock price each spread is at expiration of the October options on the 21st using the August 24th prices as a guide:
August 24 ,2012
September 28 ,2012
GOOG at $680
GOOG at $755
If you were to buy the November-October calendar spread today, you might pay an average of about $6.75 depending on how far the strike is from the current price of GOOG. In just under three weeks, that spread should be worth as much as $15.25 if you were lucky enough to pick the strike which is exactly where the stock price ends up. That works out to about 125% on your investment.
If you were lucky enough to pick a strike price that is $5 away from the stock price on October 19th, you could expect to sell your spread for $12.75, and almost double your money. If you are $10 away, you could expect to sell your spread for about $10.70, making a gain of about 58%.
Bottom line, if you pick a strike price which ends up being less than $20 away from the stock price on October 19th, you should make a profit from the spread. If the stock is more than $20 higher or lower than your strike price, you would lose money.
I am long GOOG. I bought some shares a few years ago for $325 and have just hung on to them, sometimes selling a well out-of-the-money call against the stock (and always buying the call back if there was a chance of losing my stock at expiration). Although I like the stock, I have no idea which way it is likely to move after an earnings announcement. I have guessed many times in the past, and am quite certain that I have a perfect record of being right or wrong an equal number of times.
Since I believe the actual change in the stock price is essentially a crap-shoot, I typically buy calendar spreads at several strikes, some above, some at, and some below the stock price. That way I increase my odds of hitting the right strike or two and doubling my money on at least one or two of my bets.
I have bought November-October calendar spreads at every strike between 735 and 775. As long as the stock changes less than $20 in either direction between now and October 19th, I should make a gain on at least 5 of the 9 spreads, and one of my spreads will make about $800 which is greater than the maximum I would expect to lose on the two worst-performing spreads added together. If the stock stays flat, I should make money on every single spread.
If the stock moves up by $5 next week, I will add a new spread at the 780 strike (or at the 730 strike if it falls by $5).
Another way of playing this game is to pick the strike where you think the stock will be on October 19 and make a single bet. You might double your money. If you are within $20 of picking the right price, you should make a profit.
On many occasions, I have make similar calendar spread purchases on Apple prior to earnings announcements, and have made gains most of the time. See my recent Seeking Article - How We Made 613% With Apple Options in 7 Weeks and Expect to Do It Again in 4 Months.
However, GOOG looks like a better bet right now. GOOG seems to have matured a bit more over the years, and earnings announcements do not seem to have as much of an effect on the stock price as they did in the early years when the company was more secretive about how things were going.
Whatever you do, your odds of winning are quite a bit greater than a lot of option ideas I have seen advocated lately. Certainly, calendar spreads are potentially more profitable than going to the race track or playing the slot machines where the odds are firmly against you. I wish anyone who plays this little game a lot of luck, and fun guessing the right strikes.
Disclosure: I am long GOOG, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.