Before I begin, I want to invite you to my upcoming free webinar, Getting Started with Options:
2 High-Probability Strategies for Consistent and Easy Income next Thursday, July 26 at 6:00 pm ET. I will discuss several income-based options strategies with a few action-specific, real-world trades you can execute right away — including a trade on tech behemoth Apple.
Speaking of tech behemoths, Google (NASDAQ: GOOG), Microsoft (NASDAQ: MSFT) and yes, Apple (NASDAQ: AAPL) are all reporting earnings in the next few days. Google and Microsoft are due out after the close this Thursday and Apple next Tuesday.
And I have a good idea of where their stocks are headed …
How? Look no further than the options market.
The wonderful thing about options, unlike other financial instruments, is that equity options live in a competitive marketplace.
When you look at options on say, futures products, you end up with maybe one or two major market making firms doing business.
In comparison, in the listed equity options marketplace there are generally, seven to ten major market making firms and another 20 to 50 smaller firms (depending on the product traded) over seven different exchanges.
This equates to an incredible amount of efficiency in the options market. Indeed it so efficient that we can accurately predict the expected move of a stock’s price in most cases.
Is this the perfect strategy? Of course not.
But does it work when there’s an earnings report during the week of expiration? Pretty damn close. In fact, the closer to options expiration the more accurate the expected move.
Option prices imply what the market expects the underlying stock’s move will be. Options are priced by the trading of market participants with a myriad of expectations. Options are NOT priced by using a “forward” formula that begins with the “cause” of the move in the underlying and then computing the option price.
In terms of expected moves, option prices are useful only to make an assertion such as, "given that option A trades at price X implies that market participants expect that there will be a move in the underlying of Y with probability Z between now and the option’s expiration.”
You don't arrive at the option price via a fundamental valuation technique like discounted expected earnings or something similar — which you might use to value a stock.
You use the option price to simply decide whether you think the market is overestimating or underestimating the likelihood of some move in the underlying. Then you make your trade (or not) accordingly.
So if you pair the market's expectation (from the option price) with what you think is likely to come from a specific event in the future, you can begin to decide which strategy fits the expected move of a stock.
So let’s take a look at how we calculate the expected move and what we expect out of Apple, Google and Microsoft after their respective earnings.
Expected Move Calculation = (at-the-money call + at-the-money put + out-of-the-money call + out-of-the-money put)/2 or ATM Straddle + OTM Strangle/2.
There you go. I am not going to elaborate on the formula; I just want to get it out there for you to play around with. As always, if you have any questions please do not hesitate to email me at firstname.lastname@example.org.
Google (GOOG) = +/- $26.53
Microsoft (MSFT) = +/- $0.71
So what can we do with this information?
As an option trader I can use this calculation with a strategy I use known as an Iron Condor. This is a range-bound trade and one that I like to use during earnings season with stocks that have high implied volatilities.
Google and Microsoft both fit the bill. As for Apple, well, the implied volatility is hovering around 30% which is half of what it was a month ago. As a result, I am going to take a pass on Apple during this cycle. However, I will be offering an Apple trade in my upcoming webinar.
So let’s look at Google.
The implied volatility for July options is close to 70%. That is exactly what I want to see – inflated options prices. One way to tell if they are inflated is by looking at options expiring in the following month. In Google’s case the implied volatility is only 33%. Perfect.
So if I wanted to sell a far out-of-the-money iron condor on Google, I would take the expected move of $26.53 and look to sell strikes outside of the expected range.
With Google trading at $575 the range would be roughly 548-602.
So given the expected range above I might simultaneously sell the July 525/520 puts and the 620/625 calls. Using these options means that as long as Google stays between 525 and 620 by July expiration (3 days), the risk-defined spread will make roughly 20%. The probability of success on the trade is 80%.
So the next time you hear an analyst proclaim an expected move, ask him if he uses the archaic models of fundamental analysis or the statistically-based models that are quickly taking over Wall Street.
Unfortunately, I think most will respond with the former.
Editor and Chief Options Strategist