The market was pretty strong today, with the financials leading. The Dow was up +101.79 points; SPX added +14.8 points; Nasdaq gained +32.24 points. However, the market is still below the recent high and has not broken out yet. I thought we could look instead at couple of interesting earnings to demonstrate some important, but, simple rules of thumb in playing earnings.
I actually do not play earnings all that much, not ahead of the report anyway. Earnings are, for me, less predictable by charts. Still, I find myself playing one or two of them each week during the earnings season, and, I often keep the plays in the Trading Room.
One important thing about playing options on earnings is to know the stock that you're playing. That is, you have to know how the stock can move, especially if you're positioning yourself "ahead" of the report. By knowing what the potential move on the stock can be, and combining that with the premium on the option that you want to purchase ahead of the report can give you a pretty good risk/reward scale.
For example, let's take a look at PCLN, which reported last night. PCLN delivered a strong quarter with a 3Q net income that more than doubled. However, ahead of the report, the premiums on PCLN option on both sides were sky high. For example, the PCLN weekly 535 calls closed at $14.2 ahead of the report. I won't even go into the November strikes, because the premiums on those just wouldn't make sense. Now, for PCLN to move $30 to $40 on earnings is pretty normal. Looking at the chart, on the upside, $550 is a fair target:
We can clearly see a resistance at $550, which was tested 4 or 5 times just in the past 6 months.
Now, the day before earnings, PCLN traded as high as $519 and closed at $509. The weekly 535 calls were $26 out of the money and closed just above $14. What does this mean? If you add the $14+ premium to the $535 strike, you'll get to just about $550. This means that $550 is pretty much fully priced in. This means that if PCLN finishes the week at $550, those weekly 535 calls would be worth $15. Now, is it worth to risk $14 to gain maybe just $1 of profit? Of course not!
This morning, PCLN opened at $520 and the out-of-the-money option premiums on both sides were crushed. Both sides were in the red, even though the stock gapped up $10. This is very important for new options traders to understand: premiums are much higher ahead of earnings, especially for a big mover such as PCLN; and, the premiums get crushed right after earnings.
I looked at PCLN weekly 535 calls this morning and saw them trading at nearly $7, down from the $14.2 closing price. I commented in the Trading Room:
November 8, 2011 7:05 AM
November 8, 2011 7:05 AM
looks like a breakout...
November 8, 2011 7:11 AM
premiums were too high; out-of-money options are down on both sides... now is the time to look at calls...
Why is it the time to look at calls? Because now the math makes sense. With PCLN up $20+, trading at $530+, the weekly 535 calls were now only $7 and only $5 out-of-the-money (comparing to the night before which were $26 out of the money and trading above $14). Now, looking at the chart, you know the potential is $550. If we buy the 535 weekly calls at $7 and PCLN gets to $550, we'd have a quick double on our 535 calls! Is it worth it to risk $7 to gain $8? Of course it is!
The rest is history, as we talked in the Trading Room:
November 8, 2011 7:42 AM
weekly 535 calls up almost 50% in less than 1 hour
November 8, 2011 10:55 AM
weekly 535 calls daily double!
November 8, 2011 12:51 PM
$551; those 535 calls went from $7 to $19+ intraday!
November 8, 2011 1:00 PM
climbed $33 after open! those 535 calls went over $20!
another nice day!
November 8, 2011 1:07 PM
even if you had bought just 1 contract of those 535 calls when I mentioned them this morning, you would've made more than $1000 by the end of the day!
In summary, if you're trading ahead of earnings
1) Know the stock; know what the potential move is
2) Identify a target price, then, ask yourself, is the premium on the options worth for me to take the risk ahead of the report?
For PCLN, clearly, it was not. But, when the option values got crushed "after" the report, it was worth playing!
Now, let's take a look at an example where playing ahead of the report was worth the risk. Yesterday, I mentioned in the Trading Room that ROVI was looking weak:
November 7, 2011 7:14 AM
Let's take a look at the chart:
This is a 2-year chart on ROVI. If you had just looked at a 6-month chart, you would've seen the first support, which is $40. The 2-year chart reveals the 2 supports below that: one at $37.5, and the next at $35.
Now, ROVI closed at $46.02 today and the November 45 puts closed at $1.6 with a bid at $1.45 and an ask at $1.8. The 45 puts are only $1 out of the money. The first target is at $40, at which the 45 puts will be worth at least $5. So, is it worth risking $1.6 to $1.8 to make $3? That's more than a double, so, I hope your answer is "yes"!
Wouldn't you know it? After the market, ROVI reported a lousy quarter with a lousy forecast. ROVI shares plummeted down $10 to just above $36! Those November 45 puts are going to be worth more than $9 tomorrow morning, if the after market prices stick.
1) know the stock and the potential move
2) identify a target price: the potential move is to $40, then $37.5 (honestly speaking, I did not think that it would trade down to $35!)
Is it worth to play ahead of earnings? Yes, we could easily see a double (what we'll likely get is a quadruple)!
So, before you decide to play an earnings play, see if the math works first. Also, pay attention to how the stock moves a couple of days ahead of the report, and, pay less attention to how the stock moves on the day of the report. This is because big money will position itself a couple of days ahead of the event. On the day of the event, the move can often be false to shake weak holders out.
You might think that I'm making the above sound too easy, and I am! It is just to demonstrate a couple of simple rules that you can use. They do not always work as earnings are very unpredictable, but, they can help increase your winning percentage!
Good night and HappyTrading! ™