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We recently discussed the impending release of third
quarter earnings for Google (GOOG), analyzed the expected move in light of
then-current options pricing, discussed the expected behavior of the implied
volatility of the options, and finally constructed an option trade structure
we thought had a high probability of success. I thought it would be helpful
to discuss how our prognostications fared and finally to consider
“lessons learned” in this exercise.
This
column is essentially a trade journal entry. I would encourage all traders to
make such entries routinely; each trade, whether it is economically
successful or not, has an embedded lesson. No trader ever reaches the point
at which he executes perfectly. The lesson has been paid for. It is foolish
not to capture its message.
Google was
scheduled to report earnings after the closing market bell on Thursday,
October 18. It is worth noting that most options players wait until an hour
or less prior to earnings release to enter earnings trades. These last minute
players were completely shut out because of an unexpected early earnings
release mid-day on Wednesday.
Prior to
this unforeseen early release of information the stock was trading around
$755. The stock immediately sold off and traded wrapped around $680 / share
for the next few days. This 10% sell off was the largest move on earnings for
the prior four quarters. The recent range of price moves on earnings had been
between 2% and 8%.
The second
portion of our prospective analysis was to calculate the anticipated move
that was reflected in the options pricing. We calculated the impending move
at $34.60; roughly 50% of the actual move that occurred. This means that the
move on earnings was a 2 standard deviation move, a very unusual event.
Our
statistics tell us that the 1 standard deviation calculated move of +/-
$34.60 / share would have contained 68% of the occurrences of the move. The
actual 2 standard deviation event would have contained 95% of the movement
events.
We
discussed the fact that playing earnings directionally is difficult.
Obviously those sufficiently prescient to predict this massive sell off and
structure appropriate options positions did well. In this particular case,
simply buying puts would have been a profitable strategy since the move was
so much larger than anticipated.
However,
it is critical to realize that a trading strategy that can survive over the
long haul cannot be based on statistically improbable events. Traders who
simply buy options ahead of earnings release are engaging in low probability
strategies that will not be successful when used over a sufficient number of
events that the probabilities are realized.
We
considered the example of a high probability trade, a triple calendar. This
trade was designed to deliver profit over a wide range of prices and profit
from the anticipated volatility collapse on the front month contracts.
To recap,
the original P&L curve is presented below:
 
This trade
was designed to be short term and was planned to conclude on the Friday
following earnings. The original break even points for the trade were around
$670 and $840 and were outside double the expected move. The trade had
approximately a 90% chance of profitability.
At
expiration on Friday, the planned duration of the trade, the price of GOOG
was $682, within the initially projected zone of profitability. So how did
the trade do?
It was a
scratch, losing $8. The reason for the loss was that the collapse in implied
volatility extended to the December series options we were long to a greater
degree than anticipated.
While a
negative economic outcome is never welcome, I feel quite good about the
result in light of the magnitude of the price move. I feel this is an example
of how a well constructed trade exposes the trader
to minimal loss even when price movements occur well outside the predicted
range.
Happy
Trading!
JW
Jones
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