Expiration Week Earnings Events and Long Straddles

Long Straddles Predict Volatility Before weekly options expanded to include weeklys on individual equities, it was rare for options expiration and corporate earnings reports to fall during the same week. One week, at-the-money (ATM) options have very little time value, obviously, large gamma, and negative theta. With such little time to go to expiration, the options market can provide a clear signal as to what it is predicting for the magnitude of stock returns around earnings events. This week of August expiration also includes earnings concentrated in the tech and retail sectors.

In the technology space, Network Appliance NTAP, Marvell Technology MRVL, Hewlett-Packard HPQ, and Dell Computer DELL all report throughout the week.

Retailers TJX Cos. TJX, Abercrombie & Fitch ANF, Wal-Mart Stores WMT, and Home Depot HD are all on Tuesday, with Target TGT and Sears Holdings SHLD following later in the week.

It is relatively clean to be able to look at the ATM long straddles (the simultaneous purchase of the same-strike call and put) and predict what degree of movement is expected. Remember the straddle doesn’t predict direction, only degree of the anticipated move.

Looking at DELL, for example, the stock is currently trading at $12.05 (as of Friday’s close). The 12-dollar August ATM straddle is currently bid at 67 cents. Now the value of the straddle is not 100% earnings only but it as close as we ever get with such little time to expiry. As a percentage of the stock price, 67 cents is equal to 5.58%. Of the last four historical earnings moves in DELL, three have been greater than 6% and one was greater than 10%.

In HPQ, the shares are trading at $40.45 and the ATM 40 straddle closed Friday bid at $1.49 bid and offered at $1.54. Again, calculating the mid-market premium as a percentage of the stock price, you get 3.7%. This is a little tougher to calculate as the stock is trading between two strikes and the straddle has 45 cents of parity in the premium price. If you take out the parity and do the same calculation off a $1.09 premium, the expected move is only 2.7%. HPQ is reflecting that it isn’t much of an earnings mover; in fact, the last four historical moves on earnings day reflect only about a 2% move.

So the options are certainly predicting a smaller earnings move this time around for DELL and a slightly higher-than-normal move for HPQ. Perhaps this is due to Intel INTC setting the table earlier this month for low expectations in the chip and PC space. In other words, it seems as though investors think at least some of the uncertainty of the news is out. Also, with Hewlett Packard’s corporate leadership still in flux, that may explain the slightly higher premium in this name.

Once the earnings results in these names are announced and exposed to the overall market, one expects the stock to find a new trading price, and option premium and implied volatility should come crashing in. The risk to a long straddle is 100% of its premium paid. Reward is unlimited to the upside and capped only by zero if the shares decline. The trick is to find option plays where the new parity to the traded strike is greater than the premium paid for the straddle. Expiration week earnings plays give option traders a chance to buy a lower-cost straddle on the stock. Lower cost may not mean low volatility, however.

Either way, even if you don’t play the straddles, research the weekly options (when they exist) or the short-dated expiring options to get as much information about earnings before the reports hit the wires. This may make you a more prepared stock and option trader.

Photo Credit: livingonimpulse

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