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Trading Earnings with Options: A Cautionary Tale

10/20/2010 12:01 am EST


Mark Sebastian

Founder, Option Pit LLC

During a recent option mentoring session, one of my students asked me to look at IBM into earnings. Initially, I noticed that inter-month spreads were begging the trader to take a delta-neutral calendar or diagonal bet into earnings. The front-month options were completely pumped up, and the back-month options had not gained very much value. There was certainly a good chance to take in some premium if the stock did nothing:

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(Notice the spread between November and December)

However, I then noticed something else: Paper flow. This is a list of all orders that were over 150 contracts:

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I decided to put a red dot next to every trade that I was 90% certain was a buy. As you traders can probably see, it is almost all red dots. Paper went on a major buying spree in both puts and calls. At day's end, the 140-145 strangle was trading over $5!  That is an incredible premium. My personal feeling was that the stock was going to head south, settling around 135.

Overnight, the stock was down about four or five dollars, and I think it will give away another dollar or two during regular trading hours in the next few days. The stock had run up somewhat unjustly along with several other tech stocks, in part because of the way GOOG crushed forecasts. When IBM has fallen off after earnings, there is usually some follow through. This is quickly followed up by some bottom feeders buying this widely held company. It’s almost like these guys can tell when mom and pop have told their stockbroker to sell.

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However, with this recent run up, in which IBM is closing at the highest level it has in over two years, I think we might see a little bit of an extension of tonight’s selling. My guess is that IBM is down some more tomorrow and the buyers of those November 140-145 strangles end up happy campers.

By Mark Sebastian, option trader and mentor,

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