In light of Wal-Mart Stores Inc.‘s (NYSE:WMT) bombshell announcement that it’s expecting a 6% to 12% earnings cut over the next two years, expectations are high for Amazon.com Inc. (NASDAQ:AMZN), which reports earnings after the bell today.
The volatility I’m seeing with AMZN shares tells me traders are afraid Amazon might not deliver on earnings.
It’s always difficult to predict which direction a stock will break around earnings. The slightest bit of news could send a stock soaring… or crashing.
Last week, I showed you how to construct a Straddle, a non-directional trade that’s perfect for when you can’t tell which way a stock is going to move.
Ahead of earnings – and all the uncertainty and volatility that comes with it – is AMZN a ripe for a straddle?
Let’s take a look…
The Chart That Only 1% of Traders Ever See
The blue line you see moving up and down, that’s not a moving average, or any popular technical indicator. That line is the implied volatility for the near-money options that trade on Amazon, and it’s really rare, valuable data.
Here’s what it means for us.
I like to call this line the “fear factor” line. As the line goes down, there is less fear of the day-to-day movement of the stock. As the line goes up, so does the uncertainty about the future, and of course, options prices.
For Amazon, the options implied volatility trades in a range of 20 to 80. If the line goes from 20 to 80, it basically means that an options time value theoretically increases by a factor of four.
Now a smart straddle trader would try and buy when volatility is low and sell when volatility is high.
In hindsight, buying a straddle a few weeks ago would have made a lot of sense – option volatility has actually risen with price.
Most novice traders actually think buying a straddle and holding it through earnings makes sense, because they have seen big moves happen on the stock, and have the idea that a trade like a straddle will make money on the big move.
But it’s not as easy as it sounds, so let’s take a more experienced approach to see if this indeed is a good idea ahead of this week’s earnings on AMZN.
First, let’s create an outlook for this week’s Amazon earnings. Even though most people know that Amazon has met or beat expectations in three of the last four quarters, I am more interested in what the stock did before and after earnings…
So in the week leading up to earnings the last four times Amazon reported, we saw an average share-price move of 4.18%, mainly to the upside. This was before earnings, but not through earnings.
Now, in the days following earnings, AMZN stock moved an average of 15.31% with three out of the four quarters moving higher by double digits.
Put these two spreadsheets together and you are talking an average 20% move to the upside on the stock, in three of the last four quarters.
AMZN: Here’s How We’ll Play It
First it makes sense to actually look at the near options expiring this week. This gives us a gauge of how far the stock could go just after the report.
As of earlier this week, AMZN October 15 2015 $570 (AMZN151015C00570000) calls and AMZN October 15 2015 $570 (AMZN151015P00570000) puts expiring this week are trading at around $50 when combining the costs together. That’s what I like to do to get a read on where this stock might go after earnings. We want to see the range right around $50.
Now we have to consider the likelihood that Amazon stock will head higher after earnings. I think the shares have a 75% chance of heading higher, against a 25% chance of heading lower.
But this does not – repeat, not – mean we should go for a straddle…
First, the straddle above would cost $5,000 per contract to buy, which already violates a major rule for me. Next, buying a straddle and holding it through earnings will stack the odds against you.
Buying a straight call option puts you a bit further into probability’s favor, but only just – and before the probability traders our there start writing angry comments, remember there are two kinds of probability that concern us here:
Statistical probability – with options, when you bet on the long shot, you could win more, but of course the odds of winning becomes far less. Don’t let the probability calculators fool you into thinking that naked options selling is the only way to trade, it’s just a guide and should be treated as such.
Remember Long Term Capital Management? They used to be a big name, just like Tyrannosaurus Rex and the dodo. Well, LTCM’s Myron Scholes helped create the Black-Scholes Option Pricing Model that most calculators are based on – before the company went bankrupt trading on the theory and almost scuttled the American economy back in the 1990s.
We are banking on historical probability for this trade. While not perfect, it’s the lifeblood of a Rules-Based Trader. Follow the pattern. And the pattern here suggests we do something bullish.
So what’s the best way to play AMZN this earnings season?
The “loophole trade” offers the least risk, most reward, and best probability for option buyers.
Creating a short-term bullish loophole trade that expires this week makes sense to those who believe AMZN could pop $50 by Friday. Here are a few examples of where some spreads are right now using AMZN October Week 4 options:
AMZN October 23 2015 $575 (AMZN151023C00575000) calls mid quote at $18.85
AMZN October 23 2015 $600 (AMZN151023C00600000) calls mid quote at $9.52
AMZN October 23 2015 $615 (AMZN151023C00615000) calls mid quote $6.15
AMZN October 23 2015 $625 (AMZN151023C00625000) calls mid quote at $4.02
Prices as of Wednesday, October 21 Noon EDT
Now, don’t let the colors scare you, I did this to point out three different examples that suit the risk tolerance of most investors.
The green highlighted option has the highest risk, but the lowest breakeven point at Friday’s close.
The yellow in the middle has lower risk and higher reward, but a higher breakeven.
And the red highlighted option offers the lowest risk and highest reward. Nothing is guaranteed, of course, but any one of these strategies will get you paid handsomely when Amazon.com’s expected post-earnings breakout takes shape.
Here’s your trading lesson summary:
A non-directional options trade, such as a straddle, is often a good way to play an earnings announcement. Is today’s earnings announcement the right time to straddle AMZN?
- Implied Volatility is a great indicator to use if you want to build a straddle – a smart straddler buys when volatility is low and sells when volatility is high.
- Look at the historical data – such as the stock’s behavior following the last several earnings reports.
- Research the cost of short-term at-the-money options and see if they align with your personal risk tolerances and trade plan.