Tap Into Earnings Volatility

This alert was originally sent to subscribers of TheStreet.com Options Alerts on July 26 at 1:56 p.m. EDT.

As I mentioned in Monday's Weekly Outlook, the drug firm Abgenix (ABGX Quote) is slated to report earnings after the close July 26, and trading volume and volatility have been moving higher prior to the report. This is setting up a trading opportunity.

The implied volatility (I.V.) of Abgenix's front-month options have risen to the 75% level, from around 65% two weeks ago. The stock's real, or historical volatility (H.V.) has been running at just 40% over the past 30 days, suggesting the options are pricing in a move far in excess of their historical statistics. Abgenix's relatively stable stock price combined with a rich option makes this a good candidate for establishing a covered call to reap some short-term gains. There are no known, impending drug- test results or court rulings that could unhinge the stock in the next few days. With the stock currently trading around $10.40 a share, one should be able to sell the August $10 call option at $1.00.

This buy-write offers nearly 9.7% of downside protection. Based on ABGX's past six months of historical price- volatility data, I calculate the likelihood of the shares breaking below the break-even point of $9.40 within the next five trading days as less than 6%. To boot, the stock's daily chart shows good support at $10 a share. I expect the buy-write should take advantage of contraction in the implied volatility following the release of the earnings, barring a surprise announcement, such as a major disappointment or revelation of a new lawsuit or investigation. I anticipate I.V. to retreat back below 60% by the end of the week.

Suggested Trade:

-- Buy 500 shares of ABGX at $10.40;
-- Sell five August $10 calls (AZGHB) at $1.00.

The maximum profit of 60 cents per contract, or $300 for the five contract buy-write, is achieved if ABGX remains above $10 a share. This would represent a 12.7% return on investment (ROI is based on this position's initial margin of $2,350) for a three-week trade. I doubt I will try to wring out the final pennies in the final days, but I would look to close the position at a price that offers a 10% return at the soonest available date.