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How to play Google earnings with option strategies.

|Includes: Alphabet Inc. (GOOG)

Google announces earning this afternoon. Will it be a positive surpirse? Negative surpise? Will Google go up tomorrow, or will it plummet?

I have no idea.

It is in times like these that I turn to a couple of friends of mine- the straddle and the butterfly spread. The combination of earnings announcements and options expiring the same day usually makes for some exciting action.

The first question we have to ask when deciding whether to buy or sell a straddle or butterfly is this: do I think that the underlying security is going to be volatile and have a big move? Or do I think that the stock is going to hang around where it is right now?

When buying a straddle, you are buying an at-the-money call and an at-the-money put. This position basically implies that you don't know which direction the stock is going to move, but you think it is going to move big. Selling a straddle would be the opposite, planning on the stock staying put.

In the case of Google, we can make our decision by looking at the average post-earnings moves over the last five years. By using Bloomberg's ERN (earnings) function, we can pull up a list of all the earning announcements for Google over the last few years. Bloomberg provides us with the expected earnings, actual earnings, % surprise, and % change in the price of the stock after the announcement. It is the "% change in price" column that I am interested in.

Looking at the % Price change of the stock on the day after earnings, I can get an idea of what kind of a move Google usually has on the day following earnings announcements. Because I don't know or care which direction the price is moving, I will average the absolute value of % Price changes for the days after earnings announcements. This will give me an idea of, on average, how much Google moves the day after earnings, whether it be up or down.

So, taking the data from the table, we will use the absolute value of the % Px Change column.

etc going all the way back to 2005.

After I've got all of these values, I find the simple average, which turns out to be about 6.3%.

Let's recap. What this 6.3% number tells me is that, on average, Google has a positive OR negative move of 6.3% on days following earnings announcements. That's a pretty big move.

So, do I want to buy the straddle or sell it?

Well, by running a P/L analysis, we can find out.

If we were to sell the at-the-money (625) straddle, our breakeven points would be somewhere around 655 and 595. This means that we would make money as long as Google stayed within those bounds. That sounds like a big gap, but those numbers only give us about a 4.8% cushion. If Google moves, on average, 6.3% after earnings, then this straddle would be a bet against the house.

So, why don't we buy the straddle? Running a similar P/L analysis, we see that if we bought the 625 straddle, our breakeven points would still be about 655 and 595. This means that if Google closes outside of these numbers, we make money.

These numbers represent a move of 4.8% in either direction. Given that we assume that Google moves on average 6.3% after earnings, the odds would be in your favor if you bought the straddle. It's risky, though- if Google closes at 625 tomorrow, you stand to lose your whole investment, which would be about $31. But, for every point that Google moves beyond 655 or 595, you make money, and the upside is unlimited.

For the risk averse, may I recommend the Butterfly Spread? The butterfly spread is simlar to the straddle, except that we sell an out of the money put and and an out of the money call to protect ourselves in the event that the trade doesn't work. 

The P/L scenario on the butterfly would be an investment of about $19. Should Google close at 625 tomorrow, you stand to lose it all. However, the butterfly gives us less cushion on the breakeven points, so if Google broke outside of 643 or 606, you stand to make money. These breakeven points represent about at 3% move in Google, which is much less than the 4.85% breakeven points given by the straddle.

The butterfly spread limits our risk by making the max amount we can lose $19, vs. the $31 we stand to lose if the straddle doesn't work. What you give up, however, is upside. The straddle has unlimited upside, where the butterfly has about a $6 upside.

Is it guaranteed to work? Heck no. We have the odds in our favor, but that's it. It's a gamble to see where Google ends up at the end of the day tomorrow. Is it worth it to you to put up $19 in hopes of making $6? A chance to make a 33% return over 24 hours doesn't come along often...

These option scenarios are always fun to run when the perfect storm of earnings announcements and options expiration happen on the same day.

Good luck and make good decisions.