Option Trading Strategies
The Smart Profits Report: Issue #282
Thursday, February 9, 2006
Option Trading Strategies - Option Plays That “Earn” Their Keep… To the Tune of 633%
By Steve McDonald
Advisory Panelist, Mt. Vernon Research
When Cymer (Nasdaq: CYMI), a leading supplier of semiconductor light sources, recently exceeded earnings expectations, its stock spiked, sending one of its options up a delicious 923%.
An option on Novellus Systems (Nasdaq: NVLS) ran up a healthy 526% on positive results. As did an option for Openwave Systems (Nasdaq: OPWV), increasing a relatively modest 450%.
These gains averaged out to 633%, and each of the options made their mark in January, which is one of the biggest earnings reporting seasons of the year.
So, what’s going on here? Why did these options skyrocket? What kinds of option trading strategies could I use? It’s typical to see positive earnings drive prices higher, but these returns were extraordinary, and I wanted to know why. After hunkering down and digging through the numbers, here’s what I found…
No Surprises - Exceeding Expectations Is A Well-Paying Habit
Hopefully, you’ve been around long enough to know that you shouldn’t expect returns of 633% on a regular basis. They do happen occasionally, but rarely in a group, the way these occurred.
As I searched the data to see if I could find a statistical reason for it, I had hoped for some new correlation, or an undiscovered indicator that would make me rich and famous using a specific option trading strategy. Instead, I confirmed what I have known for a long time: Earnings drive the market. But, in this case, a particular earnings history makes a significant impact.
My search revealed that each of the above three companies had exceeded their earning estimates over the last four quarters. In fact, Cymer beat expectations in four straight quarters. And Novellus and Openwave Systems beat the Street in two out of four quarters. The amounts by which they beat the estimates didn’t seem to matter, only the fact that they exceeded them.
This confirmed my belief in earnings as the primary indicator of market success, but it also suggested what I have suspected for a long time: Investors are quick to jump on bandwagons, and they’re even faster to jump off based on their expectations, not the facts.
Since exceeding earnings is the one thing that almost guarantees a run-up in the stock price, it would seem investors expect the three companies mentioned here to exceed their earnings next quarter. Hence the big spike in the option prices. As with all aspects of the market, there are several ways this could play out.
In general, here’s how I have seen stocks react in this type of a situation:
- If the company meets, but doesn’t exceed, its quarterly earnings, chances are the stock will drop slightly.
- If it comes in below expectations, there will be a lot of disappointed investors. The stock will do its falling-rock imitation.
- There is very little chance there will be no movement in the underlying stock price. There has been too much activity to expect nothing to happen.
In the case of these three stocks, it appears the expectation of exceeding earnings again has driven up the calls and crushed the puts. Reasonable, if you buy into my assumption about what investors expect to happen.
Which Option Trading Strategy Is Best?
This was the perfect situation for an option strangle, where you buy the calls and the puts with the same strike prices and expirations - an option trading strategy I use frequently. An option straddle would also have been suitable. Each one allows you to play both sides and take advantage of the law of averages.
The difficulty in using a strangle, of course, is knowing whether to actually wait for the earnings announcement, or take the gains off the table before the new numbers even come out. After almost 25 years of having the market beat sense into me, I say, take the money and run. If I’m sitting on big gains, my rule of thumb is a simple question: When was the last time I had gains like this is less than a month?
Experienced options investors are realists. They don’t allow themselves to be swayed by the herd’s often-irrational behavior.
As the earnings season develops, I will continue to follow up on any big winners and check for further support of the relationship between exceeding earnings estimates and option performance. I’ll let you know what I find.
Keep your expectations in line with the facts, and be disappointed less often.
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Today’s Smart Profits Cribsheet
- What’s the difference between strangles and straddles? Strangles are very close to straddles in the family tree of options strategies… The only difference is that in addition to having the same expiration date, the calls and puts of a straddle must also have the same strike price. For more options terms and definitions, visit the Smart Profits Report Glossary.
- For a step-by-step look at how strangles work, visit Smart Profits #257, Options Strangle Tips - Extracting Three Strangle Tips From a 515% Gain.
Good Trading,
Steve
Related Articles:
- Options Trading Strategy - A Five-Question Screen to Find the Perfect Option
- How to Get the Best Price on Your Options
- Strike Prices - Increase Your Odds by 99%
- Two Ways to Profit Trading Index Options
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