Three Potent Tech Options Plays

Here's how to play Amazon, Apple and Baidu ahead of their earnings reports.
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After the breathtaking rally in Google (GOOG) - Get Report after last week's earnings report, traders' eyes are shifting to three big names -- Apple (AAPL) - Get Report, Amazon (AMZN) - Get Report and Baidu (BIDU) - Get Report that all report earnings this week, hoping that lighting may strike twice.

Great Expectations

Google's 20% move certainly ups the ante for expectations of a large price move following these companies' earnings reports. The implied volatility of Google options had been pricing in about a 7% price move for Google. In retrospect, this was somewhat low relative to the fact that the historical volatility had been rising in preceding weeks and was basically at par with the implied volatility. It's somewhat unusual for IV to be equal to the HV, especially before an earnings report. Click

here to see a graphic representation. In retrospect, regardless of your directional bias, buying premium in Google ahead of earnings, simply on the basis of relative value, made sense.

Get Bearish on Baidu With Options

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Volatility Rising

This may not be true for the three names mentioned above. Aside from the fact that all have now enjoyed large price move in the past week, something that Google did not experience before its earnings, the implied volatility of their options has been ratcheting higher. As author of

TheStreet.com Options Alerts

, I keep my eye out for these sorts of opportunities, so let's take a look at today and tomorrow's tech reports and some option plays on them.

For Amazon, which reports earnings on April 23, the stock has gained 8% in the past week, and implied volatility has increased to 65% or a 12 percentage point premium to the historical volatility. Click

here for a graphic. With an 11% price move now priced in, buying option premium or being long gamma does not seem too attractive. I'd rather look at selling a

strangle or better yet limiting risk by using an

iron condor, which consists of selling both a call spread and put spread, each for a net credit.

For example, with Amazon currently trading at $80 a share, one can sell the May $85 calls and buy the May $90 calls for a credit of $1.60 for this bearish call spread. Couple this with selling the $75/$70 put spread for a net credit of $1.80, and one will be collecting $3.40 in premium.

This creates a position with a maximum profit of $3.40, which would be achieved if shares of Amazon are between $75 and $85 on the May 16 expiration. The maximum loss is just $1.60 and would be incurred if shares close below $70 or above $85, a 12% move, on the expiration day. That's an attractive risk/reward for a limited risk position which has a profit zone that spans a 15% price range over the next three weeks. Remember, the break-even points are $71.40 and $83.50, or a $12.20 price range.

Of course it is not necessary to hold the position until expiration to realize a profit. That is because no matter what the response to the report, implied volatility is sure to decline immediately after the earnings release.

Even Google's options, which basically experienced an outlier event, saw the IV of its options decline 25% on Friday. But the magnitude of the price move outweighed that negative impact of the earnings vega crush, and owning options proved profitable.

So the question for Amazon is, will its price move beyond the 12% that is currently being priced into the options market? I think the play is to use the condor, which because of its limited risk has natural stop levels built into the strategy, and benefit from the fact that implied volatility will decline after the earnings report.

Apple

Apple is set to report earnings after Wednesday's close, and is a tough one to game. Evidence of investors' nervous anticipation is seen in both the implied volatility of its May options and the recent price action of the stock. Implied volatility has increased dramatically to the 60% level, which is a nearly 20-percentage-point premium to the stock's 30-day historical volatility. To view the graph showing the recent climb of IV over HV,

click here

.

The stock price is also getting jittery. After eclipsing $200 a share in December, the stock lost its momentum and tumbled sharply over the next two months, hitting $120 in February. Apple has enjoyed a nice, steady recovery, gaining some 25% in the past three months to a recent high of $171 a share, but today it is pulling back to around $160 a share.

The consensus seems to be that the stock is now fairly priced for the upcoming earnings report and that there are relatively few major catalysts to propel the stock much higher in the near term. As the iPhone continues to roll out and enter overseas markets and the next holiday season comes in fall, the company's longer-term prospects remain quite bullish.

Under this scenario, a

calendar spread

-- more specifically a diagonal calendar spread -- might make sense. For example, one can buy the October $170 calls for about $18 and simultaneously sell short the same number of the May $165 calls at $10 a contract. That is a net debit of $8 for this calendar spread. The position should benefit from the decline in IV that will occur following the earnings report, which will be more dramatic in the May options than October options. If the stock declines following the earnings report, one will quickly collect the premium from May options sold short; in this way you will have reduced the effective cost basis of owning the October options.

If the stock rallies after the earnings, one might need to make an adjustment and roll the May option up to a higher strike price. Or even out to the June series. For example, if Apple jumps above $170, one might buy back the May $165 calls and sell short June $175 calls. In this way you will have still taken in some premium and maintained the calendar spread that provides a lower-cost way of owning the longer-term October calls.

Baidu

Baidu, often referred to as the Google of China, has certainly taken its cue from Google's positive earnings report and resulting rally. Shares of Baidu are up some 18% to around $350 in the past five trading sessions.

With the company scheduled to report earnings Thursday, the implied volatility of its options has marched up to above the 80% level, indicating that traders are anticipating a 10%, or $35, price move. While option prices are not indicative of direction, only the magnitude of the move, given the recent rally the stock seems more vulnerable to a sell-the-news response.

I might consider using a bearish

ratio spread

as a way to profit from a decline in both the stock price and the implied volatility of its options.

For example, one can buy one May $340 put for about $23 a contract and sell three May $300 puts for $10 a contract. That is a net credit of $7 for a 1x3 ratio spread. What's nice about receiving credit is that even if you are wrong and the stock rallies, you can still make money by collecting that $7 of premium.

But the maximum profit of $47 would be realized if shares decline to the $300 level at the May 16 expiration. Of course, one could close the position for a profit much sooner if the stock is declines below $330 following the earnings report.

But be aware because this position is net short or has "naked" options, it carries the possibility to incur large losses. In this case, the downside breakeven is $280 a share. So if Baidu plummets more than 20%, the losses will mount quickly.

These are just illustrations of some different approaches to using options ahead of a company's earnings report. One should always make sure to choose a strategy that best aligns with one's own opinion or investment thesis.

Steve Smith writes the Options Alerts newsletter for TheStreet.com. Each week Smith prepares a winning cocktail of options trades for his subscribers. He's currently got options plays on a variety of companies including Google, Tetra Tech and Ciena.

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;

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