Lessons from GOOG earnings

by Dan Sheridan on July 15, 2011

GOOG Price Chart
is up an amazing $66 to $595 with about an hour left to go! 13% in 1 day. Call buyers, straddle buyers, call vertical buyers , and put vertical sellers were richly rewarded. Put buyers, straddle sellers, call vertical sellers, and calendar traders were destroyed. There was no time to adjust or get out of the way. Like the old sports show Wide World of Sports used to say, the thrill of victory and the agony of defeat. Welcome to Earnings Day! It is one of great anticipation and excitement. It is also a day your losses can be severe. This is speculative trading at its best, you know the day of the move, you place your trade and wait for the result. There is no thrill like hitting a home run on earnings day and making 50-100% on your money in 24 hours. On the other side of the coin, this is a day that has no mercy for losing trades. When you are wrong, the losses are substantial.

Earnings Day Tips and lessons

#1 Be willing to lose your entire investment on an earnings play!
This will keep your size to a very respectable level. Thursday at the end of day you could have sold the 560-565 call vertical in July expiration for $1.30. What if we sold the credit spread 10 times? That would be a credit of $130 times 10 or $1300 . We would make that if GOOG closed under 560 in 1 day. Seems like a slam Dunk. No way GOOG could jump over $30 in 1 day from 529 to 560! Today , with GOOG at 597, the spread is trading at $5 and we would be down about $3700, almost 3 times our potential profit! Ouch! If a loss of $3700 causes me to spend a few days in the outhouse, my size was too big. There is no adjusting most earnings plays, your right or you are wrong!

#2 How to pick strategies around earnings?
Don’t pick strategies by selling high implied volatility and buying low implied Volatility. Before you do, ask yourself an important question: Why would the market makers give you such a great deal? Answer: They wouldn’t!! GOOG July option volatilities were over 100 and August option volatilities were in the low 30’s all day Thursday. The market was expecting the move to happen in the July cycle and they were expecting at least a 5% move. How do I know that? The long straddle is a good indicator of the expected move by the Market Makers. At the close Thursday , the at-the-money July 530 long straddle was priced at around $27. This meant a buyer of the straddle needed a move to $503 or $557 just to breakeven. The Market Makers were pricing in a 5% move ( 27 divided by GOOG price of $529). Are the market makers brilliant? How did they know to price in a 5% move? They simply read the same newspapers as you and have seen that the average move on earnings for the last 5-6 earnings is around 5-6%, miraculous! If you expected GOOG to move by more than 5% , then you would of considered long straddles, debit vertical spreads or long options. If you felt GOOG would move less than 5%, then you might have considered credit spreads, calendars, or butterflies. Again, I want to reiterate ( excuse the big word), don’t make your strategy decision on earnings based on the high volatility, it is a given the implied volatility will come down after the event. Make your decision on whether you think the price will move more or less than expectations. Then pick a strategy to match that opinion. Remember, this is an unforgiving speculative trade. Be prepared to lose entire dollar amount of trade, that will force you to watch your size and the strategies risk/reward.

I’ll be in Denver with CBOE August 11 for 1 day seminar, love to see you there!

Dan Sheridan


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