Wednesday, July 18, 2007

Earnings strategy

For this quarter, I plan on evaluating a few strategies on investing. I definitely want to research this quite a bit more before I bet real money on it. Earnings is a notoriously volatile time for stocks. A company can have profits increase by 50% and still have a stock price drop of 15% because revenues were 1% lower than expected. It really makes little sense.

Anyway, the companies I watch tend to react violently one way or the other. It's fairly rare that the stock doesn't move considerably up or down. We'll start out by looking at Google (GOOG), because it's closing price on Tuesday of $555.00 is ideally suited to such an analysis, being halfway between two strike prices.

So, GOOG earnings is July 19. I wouldn't want to buy options for July, as those expire on the 21st. Chances are that I'd lose everything. Instead, I'll look at August contracts.


As you can see, puts are relatively cheaper, meaning people expect Google to rise. I tend to agree with this prediction, but that's not the exercise at hand. I'm trying to figure out what exactly will happen if I purchase both calls and puts right before earnings. I will definitely lose a day of time value, which is a fairly significant portion of the month of time remaining.

If the stock price rises, the calls will gain value and the puts will lose value. The delta (change in option premium for every dollar change in underlying stock price) gets higher as options get more valuable, though. This ends up keeping the premium at least as high as the stock price - strike price (for calls). What this means is that as the stock moves in one direction, the profitable contract should theoretically start to gain value faster than the losing contract loses value. Also, if there is a significant move one way or the other, the volatility will increase, further improving the profitable contract's price while padding the fall of the losing contract.

Now, if the stock doesn't move much, then the time value lost will outweigh any of the above considerations. I estimate this to be well under a 5% loss for the day, though. I also need to look at the effect of trailing stop orders and regular stop orders. For GOOG, I'm currently thinking something along the lines of a trailing stop on the call that would trigger a trailing stop on the put. I'm hoping this would make the call's spike right after earnings result in maximum profits and then trigger an order to take advantage of any overcorrection or profit taking.

Over the next week or two, I'll do some virtual trading and see how things work in practice with various stocks/options. I'll keep you posted.

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