How do you properly prepare to trade stock options into an earnings report? I believe the two strongest tools we have going are past earnings reactions and what the options market is suggesting the predicted move will be.
Study the Past Earnings Releases
Let’s look at America Online (AOL) who report earnings before the market open on May 7. Given the at-the-money implied volatility for options expiring a week from today, the market is pricing a one standard deviation move of 9.15% or $3.93. The big question you have to ask yourself is: “ok great, in which direction”? Looking at past earnings releases we see that AOL has declined in price only twice in the last two years. For whatever reason, AOL performs well on earnings. That in and of itself is not a reason to take a long position into an earnings report, but its one piece of evidence.
Analyze the Chart
Next, we look at the price chart. We see that the market has tried to breach the $40.50 level four times since mid-March and failed miserably. We see that it has now broken and held above the 50-day moving average at $43.10. Again, a bullish piece of evidence. If we take the present price of $43.50 and price a one standard deviation move into it, we are targeting a price level of 47.50.
Trade Set-up
Buy the May 9 45.5/47.5 call spread for a debit of $0.50. This will afford us a reward to risk ratio of 3:1. This is calculated by taking our maximum gain of $1.50 ($2.00 wide spread less the $0.50 we paid to get in) divided by our maximum loss which is equal to the cost to get in of $0.50. $1.50/$0.50 = 3. Very favorable odds given the technical/historical picture we have painted.
= = =
Learn more about Trading Advantage here.
RELATED READING
Read a story by Trading Advantage’s Larry Levin in the Spring TraderPlanet Journal here.
