Using Options to Assess Earnings Expectations

On his Daily Options blog, Adam Warner discusses how to use implied volatility as a down and dirty way to get a handle on the magnitude of price moves the options market is pricing in ahead of an earnings report. A key point here is it only indicates magnitude, not the direction.

He takes a look at Google (GOOG - commentary - Cramer's Take), which reports earnings on Thursday, and comes up with expectations for a 4.3%, or $24, price move in the Internet giant. He also concludes that options are actually overpriced and the move will actually be less than that.

In attempt to help illustrate how he arrives at these numbers, I'm going to take a look at former Internet giant Yahoo (YHOO - commentary - Cramer's Take), which reports earnings on Wednesday. And despite its diminished stature, investors are actually expecting quite a large price move -- in the $2.10, or 8%, area -- following the earnings report.

How do I arrive at that number? One way is to simply take a look at the current option prices of the near-the-money strangle, in this case, with Yahoo stock trading at $26.50, the $25 put is trading around 55 cents and the $27.50 call is trading around 60 cents. This is a value of around $1.15 for the strangle, giving the options an implied volatility in the 75% range.

The next step is to assume that immediately following the earnings report, regardless of the ensuing price move, that the IV of the options will decline back to its 20-day average around the 40% level. If Yahoo's shares remain between $26 and $27, the decline in IV will cause the value of the strangle to decline about 27%, to around 30 cents.

For the owner of the strangle to make money, the shares would need to be beyond the breakeven points, which using 40% implied volatility, are $24.40 on the downside, or $28.20 on the upside. But given that the 20-day historical volatility of Yahoo has been a mere 17% -- and that the acceleration of time decay will go into overdrive in the last two days prior to expiration -- assuming a 40% IV after the earnings might be quite generous.

This leads me to think that selling the strangle might be the better play. If one wants to cap or limit the risk, an iron condor can be created by purchasing the July 22.50 puts for a nickel and the July 30 call for 10 cents. This reduces the total net credit to $1, but will deliver the maximum profit if shares of Yahoo remain between $25 and $27.50, a 9% range, for the next four days. The breakeven points are $24 and $28.50, a 13% range. The maximum loss is capped at $1.50 if shares fall below $22.50 or rise above $30 on Friday's expiration.

One can use the free tools available on iVolatility.com to look at both historical and current implied volatility, and the option calculator, to see what impact a change in IV will have on the options' value

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Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

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