No matter what happens with Facebook's (FB) coming earnings report, you can profit by using stock options.
Facebook plans to report results on April 27, and this tech giant is capable of delivering big surprises that can have a significant impact on its stock price. Look at its last earnings report, on Jan. 27, for example. Adjusted earnings per share came in at 79 cents, blowing away the average estimate from analysts of 50 cents. Shares rocketed nearly $15 higher in the following session and drifted even higher in the next week or two.
A couple of weeks ago, analysts at Deutsche Bank warned that the companies first-quarter results wouldn't be so strong, and the stock sold off sharply. Still, shares are up about 4.8% so far this year.
There is a lot of uncertainty surrounding the coming earnings announcement, and no one really knows what the stock will do following the news. Will the market focus on how well Facebook is monetizing its incredible traffic, its earnings growth, its sales, or its guidance? Maybe inroads in China or early sales of its Oculus Rift VR headset or the prospects for Messenger chatbots will be the hot button for investors. Who knows?
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There are some things that we do know, however:
- The implied volatility of the Facebook options that expire on April 29 (just two days after the planned earnings announcement) is 52, a staggeringly high number. Remember that implied volatility, or IV, is an important determinant of option prices: A high IV means that option prices are quite expensive and a low IV means that option prices are relatively cheap.
- The implied volatility of the options that expire on June 17 is much lower, at 35. These options expire 49 days later than the April 29 options.
- According to the CBOE option calculator, an at-the-money 110 option with 49 days of remaining life will be worth $5.11 ($511 per contract) if its implied volatility is 32 (the current implied volatility of the April 22 options, which expire before the earnings announcement).
You can take advantage of the wide disparity in the implied volatility of the April 29 and June 17 options by executing an options trade known as a calendar spread. In a calendar spread, you buy and sell options contracts on the same underlying stock, but your purchases and sales are on contracts with different expiration dates.
Right now, calendar spreads consisting of selling April 29 Facebook options contracts and buying June 17 contracts are a screaming buy. These calendar spreads cost no more than $1.60 (or $160 per contract, not including transaction fees). Depending on the strike price, many calendar spreads will cost even less.
The bottom line here is that if you select a strike price that is at the money when the April options expire, a calendar spread that costs $160 or less right now would be worth more than three times that amount on April 29.
We have had a lot of success trading option spreads in advance of earnings announcements. Over the past three weeks, Terry's Tips blog has showed how to leg into pre-announcement calendar spreads on Starbucks, Johnson & Johnson and Abbvie at a credit. Anyone who followed the directions now owns calendar spreads that are guaranteed to turn profits once the short options expire shortly after the companies release earnings. The magnitude of the profits will depend on how close to the strike price the stock price ends up (the closer, the greater the profit, of course).
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Over the past few quarters, Facebook's stock price has fluctuated an average of a little more than 5% after earnings. Implied volatility of the post-announcement options suggests the market thinks the fluctuation might be greater this time around. With this in mind, we'll try to increase our chances of ending up with an at-the-money calendar spread after the earnings announcement. We plan to buy spreads at three different strikes. Following are the four Facebook calendar spreads I am placing in my personal account.
1. Buy to open 1 FB Jun-16 105 put (FB160617P105) and
sell to open 1 FB Apr5-16 105 put (FB160429P105) for a debit of $1.40
2. Buy to open 1 FB Jun-16 110 put (FB160617P110) and
sell to open 1 FB Apr5-16 110 put (FB160429P110) for a debit of $1.45
3. Buy to open 1 FB Jun-16 110 call (FB160617C110) and
sell to open 1 FB Apr5-16 110 call (FB160429C110) for a debit of $1.60
4. Buy to open 1 FB Jun-16 115 call (FB160617C115) and
sell to open 1 FB Apr5-16 115 call (FB160429C115) for a debit of $1.55
These spread prices were available when the stock was trading at $109.60 when the market closed last Friday. These prices are slightly higher than the midpoint between the bid and ask quotes for each spread (you might be able to get them at the midpoint, and you should try that price before going higher).
You'll note that the trades above double up on the spreads at the current at-the-money price ($110), using put options for one of the calendar spreads and call options for the other. This assures that at least one of those spreads will be out of the money when it's closed out. (You can usually get better executions when selling calendar spreads that are out of the money.)
If you buy one of each of those four calendar spreads, you will shell out $600 plus about $10 in commissions. The risk profile graph below shows the possible loss or gain at the various possible ending prices when the April options expire on April 29. This graph assumes that implied volatility for the June options will fall to 32 from its current level of 35. As noted earlier, the April options that expire a week before the earnings announcement have an implied volatility of 32, making that assumption seem appropriate.
Risk Profile Graph for Four Facebook Calendar Spreads on April 29, 2016
The $610 investment could make more than $800 if Facebook ends up close to $110 after the announcement. The graph shows that the break-even range extends from about $101 to $121. This works out to about 10% in either direction, almost double the average price change after the last few earnings announcements, but just about the same change as last quarter when the company reported particularly surprising numbers.
The long sides of the calendar spreads will always have a greater value than the short sides, and when the spread costs $1.60 or less, that is not a lot to expect. Based on the CBOE option calculator, if Facebook stock is $5 above or below the strike price, the 49-day option will be worth $2.90 more than the expiring option, and if Facebook stock is $10 above or below the strike price, the calendar should be worth about $1.45, or very close to what you paid for it. If the stock price is more than $11 above or below the strike price, you will probably incur a loss on that spread.
You don't necessarily have to close out (sell) your calendar spread on April 29. We happen to like owning calendar spreads at strike prices just above and below the current stock price. We will probably sell the spread which is furthest away from the stock price on that day and retain the June options, selling new options that expire one or two weeks later than April 29. An at-the-money option with one week of remaining life should fetch about $1.90 (assuming an implied volatility of 32), and we will have seven opportunities to sell one-week options against those June puts or calls.
One should feel comfortable owning these four calendar spreads at what are attractive prices. If the stock fluctuates less than $10 or $11 in either direction, we should make immediate gains on April 29 (as much as doubling the investment), and at the very worst, we will own options that we might sell weekly options against over the subsequent seven weeks. In any event, we expect to be able to at least break even no matter where the stock price might end up.