Event trading with options

Event trading with options

McMillan, Lawrence G

Options are excellent vehicles for positioning your equity before an event occurs. One of the most active arenas for such trades is in individual equity options, where individual company announcements and industry-wide news create tradable events.

Certain corporate events cause gap moves in stocks: earnings announcements or warnings, takeover bids or rumors, lawsuit verdicts and governmental hearings (particularly FDA hearings for biotech companies). Option traders often anticipate these events in advance, but many times the collective so-called “wisdom” of the option market is not correct. Therefore, there can be opportunities for the astute trader, prior to these events occurring.

A case-by-case look at the types of events that frequently drive big moves in stocks can reveal the opportunities these events create.

EARNINGS ANNOUNCEMENTS

Trading earnings announcements is one of the more popular applications of event trading because it is a simple matter to find out when a stock is due to report earnings. It’s a far more difficult matter, though, to figure out how the earnings announcement will affect the stock price.

Many times, a company will announce earnings more or less in line with analysts’ estimates, only to issue a forecast that is out of line. That forecast can cause the stock not only to move a good distance, but it might move in the opposite direction from what most investors might expect, such as positive earnings but a negative forecast causing a stock to decline in price.

To rationally play these announcements, the first thing to look at is the price of the near-term options to see where they predict the stock will move. The near-term straddle is the marketplace’s collective best estimate of movement. If things line up properly, a reliable trade is to buy the straddle, rather than try to predict which direction the stock will move. With this strategy, you potentially set up to profit if the company misses its earnings forecast on either the high side or the low side, or if it makes a surprise additional announcement of some sort.

Consider this example.

Google (GOOG) closed at $548.60 on Thursday, July 19, 2007. Earnings were to be reported after the close on that day. July options were to expire the next day, Friday, July 20. The July 550 straddle was priced as follows: GOOG July 550 call:.$12.00; GOOG July 550 put: $13.70

Based on that data, the marketplace was predicting that GOOG’s earnings would move the stock by approximately 25.70 points (the sum of the call and put prices).

In this particular case, this is almost a pure estimate of GOOG’s projected stock price movement because the options were due to expire the next day and thus contained little value (such as time or volatility premium) for anything other than the earnings-related movement.

Then, once you have determined what the marketplace thinks the stock movement will be, you need to decide for yourself if that estimate is too high or too low. A simple stock chart can be useful here. Look at previous earnings announcements for this stock.

Ask yourself questions such as:

* Has it traditionally gapped?

* By how much?

* Has the gap typically started a new trend in the stock, or is it quickly reversed?

While there is no cut-and-dried formula for analyzing the straddle size, there are some guidelines that are helpful. If the stock has exceeded the expected percentage movement in most of the last quarters during the past two years, and particularly if the gap has started a new trend in the stock in past quarters, then the straddle can be bought. If not, it is probably best to go on to the next candidate.

The reason that selling straddles into earnings announcements is not a good idea is that you never know what surprise announcement the company might decide to make, in addition to the earnings report. The risks of the unknown are just too high. News involving everything from stock buybacks to splits to dividends might affect the stock a lot more than earnings could. While anything that moves the stock beyond prior expectations is a boon to the straddle buyer, the straddle seller is just too exposed to these surprises.

In this case, the GOOG July 550 straddle was trading at a price equal to 4-7% of the stock price. Doing our homework, we find out that GOOG indeed has moved more than 4-7% off its past recent earnings announcements. “Big mover” (above) shows that in five of the previous seven quarters, GOOG had made a large gap move – and (not shown on the graph) these moves were much larger than 4.7%.

So, the straddle was bought. The price turned out to be 26, which meant that any stock move to 26 points above the strike or 26 points below the strike would make money. In other words, we wanted GOOG to either gap above $576 or to fall below $524.

That evening, GOOG disappointed in its earnings, and the stock dropped more than 40 points to $505 in afterhours trading. On Friday, July 20, it opened near $509 before trading higher later in the day. Profits on the long July 550 puts were taken shortly after the opening, while the July 550 calls expired worthless later that day.

REFINING SELECTION

Because every company reports earnings every quarter, it would be impossible to analyze every straddle as the earnings date approached. But there is a good way to cut the list down to a workable size.

Let the option market do the work for you: Only consider the straddles that are extremely overpriced. That may sound like heresy to an option buyer. Why would you want to buy something that is overpriced? The reason is simple: That’s where the action is going to be. Computers using mathematical models don’t know that the stock is about to gap, so what looks “overpriced” to the computer model may actually be reasonably priced in terms of potential stock price movement.

Note that these options are not actually gaining value as the earnings date approaches (even though they are gaining in implied volatility). Rather, at some point in advance of the earnings, the collective wisdom of the option market is that the movement is going to be some number of points (26 in the GOOG example). Therefore, the near-term straddle continues to trade with a premium of 26 points even as time passes.

To a computer model, these options look more expensive (that is, to have a higher implied volatility) every day because they remain at the same price, even as time passes. In this particular case, with only one day to go until expiration, the GOOG July 550 straddle was trading with an implied volatility of 109%. That’s a huge number; normally GOOG options trade with implied volatilities around 30%.

“Volatility peaks” (page 40 shows the composite implied volatility of GOOG options graphed above the stock price chart. This is a weighted volatility of all GOOG options on any given day. Notice the peaks in implied volatility each quarter (red arrows). This is typical of a stock that has routinely made large gap moves on its earnings report.

The option market tries to forecast that movement, and to a computer model the options then become overpriced, as shown on the chart.

So, a trader can just concentrate on stocks with extremely expensive options that are about to report earnings. Those are where the big moves are likely to occur.

BIOTECH PLAY

The next most reliable application of this strategy involves biotech stocks that are involved in drug testing or are about to go before the FDA for a formal hearing.

As with earnings, the near-term straddle will tell you the marketplace’s estimate of stock price movement. But, unlike with earnings, there is no history of gaps to draw upon. This makes these straddle buys far more risky, but also potentially more rewarding.

Sometimes, when a small company receives an PDA rejection or its drug testing does not confirm the hopes for the drug being developed, the stock price can fall by 75% or more. Straddle buyers would profit nicely, of course, and straddle sellers would rue the day. So the warning against selling straddles applies here too.

In these cases, sometimes the timing of the event appears in the option pricing structure well in advance, even before there are news stories on it. Consider the following , option pricing information:

On April 30, 2007:

XYZ: 49 (a biotech stock)

XYZ May 50 straddle: 30% implied vol

XYZ July 50 straddle: 30% implied vol

XYZ Oct 50 straddle: 70% implied vol

XYZ Jan (’08) 50 straddle: 60% implied vol

From this data, we can tell that an event is expected in this stock before October expiration but after July expiration. We can tell this because the options that expire after the event are priced higher, and the options closest to (but after) the event are the most expensive. So, the option market is telling us that some drug trial results or an FDA hearing is scheduled during that time. Perhaps the company has said that it will report trial results “in the third quarter.” As time passes, and August-and September options are listed, then we can further refine the target date for the event.

In many cases, though, the biotech event date cannot be refined down to a specific day (it can for FDA hearings, but not for the potentially more profitable release of drug trial test result data). Therefore, sometimes you must buy the straddle well in advance of the actual event to ensure a position is in place when the event does occur.

An approach of buying into the events that have had expensive options for a reasonably long period prior to the event offer the best chances for success. But there is no guarantee, of course, and it could turn out that the stock doesn’t move much at all. So, plan on more losing trades with this approach, and account for occasional drawdowns. That said, it’s not out of line to expect large winners when they do occur.

Results through time show that, based on past performance, biotech plays produce slightly higher overall return to the straddle buyer than earnings events do. However, the swings in profits and losses in the biotech arena are far more volatile than in the earnings events.

EXPLOITING EVENTS

Expensive options can be a good forecaster of a large event-based move in an underlying stock. The best way to trade these is to assess the price of the near-term straddle-for that is the marketplace’s estimate of the gap move to be caused by the event. If your analysis suggests that the stock can move farther than that, then buy the straddle immediately before the event, looking to exit the position shortly after the event occurs.

Lawrence G. McMillan is president of McMillan Analysis Corp., a registered investment advisory firm specializing in options. He is author of Options As a Strategic Investment and McMillan on Options. He can be reached through, www.optionstrategist.com.

Copyright Futures Magazine Group Nov 2007

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