Was the IBM Move Priced In?

10/18/2012 7:00 am EST

Focus: OPTIONS

Stock market history is littered with surprise earnings misses and unexpected earnings blowouts, which makes trading earnings season a perilous endeavor. Andrew Giovinazzi, contributor to OptionPit.com, shares pointers to avoid a pitfall.

One of the frequent questions we take in the daily pit report during earnings season is if premium is a sale into the earnings announcement. Usually we take these on a case by case basis, but one of the best ways to evaluate this is by taking the front month options and turning them into a pure play on the event.

Take the just announced earnings in IBM. The topic came up in the Pit Report Tuesday and after Mark and I looked at the pricing, we thought the premium was bit too cheap. Turns out we were right for the October ATM straddle. After hours IBM was down over $6 when the October ATM straddle went out at just under $6. The savy trader could be buying in stock for cheap calls against the straddle. Once we did a review of the earnings reports, IBM has been showing more like $10 moves once a few days after the announcement is taken into effect.

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That is really what it comes down to. What does a trader want to sell the gamma or the vega? The Nov straddle went out bid just under $9 and could see that move in the coming weeks (don’t forget to discount the straddle value after volatility drops). The goodies you get with Nov is 4.5 more weeks to trade the position. The Oct with just 3 days to go was a stretch, but a little cheap so it made it easy to decide not to sell the straddle. If the front month is too cheap, the back usually is, too. Just because higher premiums show up on the earnings cycle, that does not always mean they are a sale. Stocks can move more than the straddle suggests and some recent earnings moves (PCLN comes to mind) in a thin, illiquid market will always be magnified worse than they probably really are.

The Trade
As we move into the heart of the earnings season remember several of the big names are up quite a bit from the last report. That could generate tempting premium to sell but don’t be surprised if we see another $100 move (up or down) in the next two week from a bellwether.

Andrew Giovinazzi can be found on OptionPit.com

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