Option Investor

Daily Newsletter, Saturday, 10/06/2007

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Table of Contents

  1. Market Wrap
  2. New Option Plays
  3. In Play Updates and Reviews
  4. Trader's Corner

Market Wrap

Erase August

You can erase the August jobs report and while you are at it you can erase July as well. The ugly period for employment was almost completely erased with a strong September report and upward revisions to the prior two months. With a stroke of the magic revision pen all the anguish from last month's employment report evaporated in seconds.

Dow Chart - Daily

Nasdaq Chart - Daily

The September Employment report posted a gain of +110,000 jobs and right inline with the official estimate of 115,000 jobs. The August loss of -4,000 jobs was erased with an upward revision of +93,000 jobs pushing the total job gain for September to +89,000. July was also revised higher by +25,000 jobs to a gain of +93,000. Counting September and the revisions to the prior two months we saw a total job gain of +228,000 jobs. That is quite a reversal from the -4,000 job loss initially reported in August and the horrible economic sentiment it created. As you can see in the chart below the entire curve has changed from last month being a multiyear low to a confirmed rebound from now what appears to be the low way back in June. Employment has done a complete reversal from the August disaster. After the revision and the September job gains this cycle of positive job growth has extended to 49 consecutive months of gains. This is the longest period of consecutive job growth on record.

Non-Farm Payroll Chart

The market liked the good jobs news and exploded out of the gate to new highs. That exuberance, rational or otherwise, faded as the afternoon came and chances for another Fed rate cut continued to fall. As the chances for an October 31st rate cut fell to around 40% the market anxiety began to climb. The strong jobs report along with some positive comments from several banks and brokers this week suggests the credit crunch is over and inflation, not recession, could quickly become the main concern. The Fed may have to take Greenspan's inflation warning earlier this week to heart and start moving back to a tightening bias. That may not be a bad situation because the markets would rather have higher growth than lower rates as long as rates are neutral. The current rate environment is considered neutral around 5%.

Next week has only a couple economic events that will interest the street. The minutes of the last FOMC meeting will be released on Tuesday and analysts will be very interested in why they decided to cut rates a full 50 points. This report will be dissected word for word. Secondly, the Producer Price Index (PPI) on Friday will be scoured for hints of inflation pressures at the producer level. With energy holding at its recent highs it is only a matter of time before it becomes a major inflation problem in the production chain.

Economic Calendar

More important than the economics will be the earnings. Next week is the start of the Q3 earnings cycle with Alcoa leading off on Tuesday. Earnings warnings have been flying fast with the ratio as of Friday nearing 3:1 in warnings over positive guidance. Surprisingly warnings, especially from the banks and brokers, have actually been a positive impact to the markets. Citigroup (C) warned on Monday that they were going to take a charge of $1.4 billion due to subprime problems and a write down of corporate loans. Citigroup stock plunged to $45.86 on the news but rallied the rest of the week to close nearly $3 higher. The gains came on comments that Citi thought the worst was over in the credit markets and conditions would return closer to normal in Q4. UBS warned it would take a $3.4 billion charge due to the credit crunch and it rallied +$5 off the prior Friday's close. Again, a positive comment about the future was the key. Deutsche Bank (DB) warned they were taking a charge of $3.1 billion and rallied +$6. Washington Mutual (WM) warned on Friday they would post earnings that would drop as much as -75%, take charge offs of $550 million and raise loan loss provisions to $975 million. Normally that would be a disaster for the stock price but WM closed up nearly a buck for the day. Merrill Lynch (MER) warned before the open on Friday they would post a loss of up to 50 cents for Q3 instead of a profit of $1.34 and take a charge of nearly $5 billion related to subprime obligations and write downs of LBO commitments. MER closed up nearly $2 on the news. Why did these warnings have little negative impact? They all said the worst was over and they were seeing signs of business returning to normal in Q4. That was exactly what investors wanted to hear. Yes, those were some nasty losses but investors were eager to learn that the crisis was over. All clear, green light, full speed ahead and no more looking back. Investors were so happy they ignored the 3:1 ratio of warnings to guidance and the billions in losses as old news.

Stock Gains For Companies Warning

Helping create a positive view of earnings was the +13 bounce in Research in Motion (RIMM) after they reported strong earnings Thursday night. The weak PALM results earlier in the week were completely forgotten and traders were quick to buy more RIMM. Granted a lot of that was short covering after the weak PALM results but it is still a gain. Goldman Sachs added RIMM to its conviction focus list and raised the 2008 price target to $147 from their prior target of $117. RIMM said business was booming thanks to the iPhone. Those looking for something more than a music/Internet phone are selecting the Blackberry in record numbers. RIMM closed at $113 on Friday.

Google (GOOG) gained +$15 to $595 after Bear Stearns raised their price target for 2008 to $700. That was nearly a $30 move for the week. Not to be outdone Jim Cramer raised his price target to $701. The Bear Stearns analyst, Robert Peck, said Google was "one of the best operating companies within our coverage universe."

Next week only has a handful of recognizable names reporting earnings but it is enough to get investors focused on the next three weeks where the real flood of earnings will come. On Tuesday we have the first Dow component to report, Alcoa (AA), Wednesday COST, LRCX and MON. Sallie Mae (SLM) will report on Thursday and we should get some more background on the aborted J.C. Flowers buyout attempt.

Partial Earnings Calendar

Up until last week the market was pricing in substantial earnings risk for Q3. Now that the majority of the major banks and brokerages have either posted earnings or warned and nobody is going out of business there is a good possibility that risk is now overstated. In other words there is too much pessimism priced into the market in relation to earnings. That means there could be a lot of explosive reports like RIMM where the good news outweighs the bad and shorts must scramble to cover. If this scenario comes to pass it could produce a strong Q4 rally. With the economy stronger than we thought a month ago, earnings better than expected and a friendly Fed the wall of worry seems to have crumbled. Hopefully there are enough shorts left to give the bulls some stepping-stones to continued new highs.

The stumbling block could come in the form of some worse than expected earnings but anyone planning to spoil the party should have already warned. It is always better to warn and then do better than not warn and do worse.

The Dow hit a new intraday all time high at 14124 but could not hold it. The Dow declined -62 points into the close but still ended with a +91 point gain. It was a good day for the Dow with only four stocks closing lower and only one losing more than 13 cents. That one was Boeing with a -2.25 loss. That loss in Boeing helped pressure the Dow into the close but it was not relative to the overall performance. The Boeing drop came when a Lehman analyst suggested the 787 Dreamliner program could be delayed by 4-6 months. Boeing is expected to release further details on its production schedule before it reports earnings on Oct-22nd. We already know there are some problems with titanium fasteners and the initial planes are being completed with some temporary ones in their place. In September Boeing's CEO assured investors it would deliver the first 787 on time in May. Initial test flights have been postponed to mid-November or possibly mid-December because of complications in the final assembly process and flight-control software. The Lehman analyst cautioned that Boeing might have to adjust earnings expectations if the deliveries are postponed.


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Even with the Boeing loss the Dow was able to notch an all time high and distance itself from the current support at 13950. Every day the Dow creeps a little higher it is getting that much closer to an explosive breakout. Monday's spike to 14115 saw three days of consolidation before the jobs gains retested that level. That gives us a trading range from 13950 to about 14120 and we closed right in the middle on Friday. The first high on Monday found some sellers waiting. The second high on Friday found those same sellers. This shows there are still some shorts alive and well and willing to be road kill sometime in the near future. When that level is broken again it could be explosive. On the flip side should support at 13950 be broken that would widen the range to support at 13800 and give us plenty of room to roam while waiting for the real earnings to begin.

The Nasdaq has already broken out and is racing ahead of the pack posting a +47 point gain on Friday and a +3% gain for the week compared to the Dow's +1.23% gain. It should be noted that the Nasdaq breakout has come without the help of chip stocks. The SOX fell almost 20 points from Monday to Thursday's lows and the Nasdaq barely faltered. This drive is broad based being helped by the Internet stocks, software and biotech stocks. Chips and PC stocks were no help due to earnings warnings in the group. If the chips suddenly start posting earnings better than the warnings the Nasdaq could really catch fire. Lam Research (LRCX) reports earnings on Wednesday. Current support for the Nasdaq is 2725 and it closed at 2778. It was a good day for techs!

S&P-500 Chart - Daily

The S&P-500 also inched over its previous resistance at 1555 to make a new closing high at 1557. The S&P has a solid pattern of big gains followed by days of consolidation and last week was no exception. Monday's gains were followed by three days of consolidation prior to the Friday short squeeze. The S&P is at a critical threshold. It needs to hold its gains at this point and move higher to thwart the bears that shorted the new high when it was reached late Friday.

The Russell 2000 exploded higher on Friday gaining nearly +2% to expand its gains for the week to nearly +5% compared to 1.2% for the Dow and +2% on the S&P. The small caps are on fire and rapidly approaching their resistance highs at 856. This will be the final stand for the bears and a quick defeat here would setup a strong Q4 rally if the earnings really do come in better than previously warned. Remember, this is the fund manager sentiment indicator and it is flashing bright green today.

Russell-2000 Chart - Daily

What could derail this rally? We still have a potential pothole when China reopens for trading on Monday after a weeklong holiday. There has not been three consecutive days of profit taking in nearly two months. There have been some rumors that the National Congress could limit ownership of shares outside the country when it meets in mid October. This could be a challenge to the seriously over bought market. They could also implement another trading tax or raise rates sharply to slow the economy. Since any correction in China would be felt around the globe that could be a problem in our economics and earnings deprived market next week. There will also be sound bite after sound bite all week speculating about the future of Fed rate cuts. After Friday's jobs report the chance of a Fed rate cut on Oct-31st fell to only 40% and it is likely to drop further next week. There are no signs of a recession and the corporate credit crunch has passed. The 50-point cut did exactly what it was supposed to do and that was shock the credit markets back to life. The Fed pulled out its defibrillator and the patient quickly recovered. The dollar rebounded on the strong jobs but fell back again on fears that the Fed might still cut rates again to help the mortgage market. Most analysts are moving in the opposite direction and suggesting the Fed will not cut again in order to protect the dollar. Lower rates put additional pressure on the already weak dollar. The Fed no longer needs to help the markets but it does need to protect the dollar and not aggravate inflation by cutting when they really don't have a need. The inflation hawks will be circling again pointing to the strong jobs and high energy and commodity prices. That means the two things that could slow the rally would be China and fear of the Fed. Other than those possibilities all eyes should be on the coming earnings cycle.

New Plays

New Option Plays

Call Options Plays
Put Options Plays
Strangle Options Plays
AMGN None None

New Calls

Amgen Inc. - AMGN - cls: 56.84 change: +1.45 stop: 54.90

Company Description:
Amgen discovers, develops and delivers innovative human therapeutics. A biotechnology pioneer since 1980, Amgen was one of the first companies to realize the new science's promise by bringing safe and effective medicines from lab, to manufacturing plant, to patient. (source: company press release or website)

Why We Like It:
The BTK biotech index has broken out to new highs, which is pretty amazing since AMGN, one of its largest components, has been under performing the group. We suspect that AMGN could try and catch up to its peers. The stock has been consolidating sideways the last few weeks and currently looks poised to breakout over resistance in the $57.75-58.00 range. We're suggesting a trigger to buy calls on AMGN at $58.01. If triggered our target is the $64.00-65.00 range, which might be a little too aggressive given our time frame. AMGN is due to report earnings around October 25th and we don't want to hold over the report. Furthermore chart readers will notice that AMGN has likely resistance at its 200-dma near around $59.50 and then again near $60.00. It's also worth noting that AMGN's P&F chart is still bearish and it will take a breakout over $60.00 to change it back into a bullish pattern.

Suggested Options:
October options expire in two weeks so we're suggesting the November calls. Our suggested trigger to open positions is at $58.01.

BUY CALL NOV 55.00 YAA-KK open interest= 5053 current ask $3.45
BUY CALL NOV 57.50 YAA-KY open interest= 1958 current ask $1.96
BUY CALL NOV 60.00 YAA-KL open interest= 5361 current ask $0.93

Picked on October xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 10/25/07 (unconfirmed)
Average Daily Volume = 11.7 million


Biogen Idec - BIIB - cls: 67.63 chg: +1.75 stop: 64.95

Company Description:
Biogen Idec creates new standards of care in therapeutic areas with high unmet medical needs. Founded in 1978, Biogen Idec is a global leader in the discovery, development, manufacturing, and commercialization of innovative therapies. (source: company press release or website)

Why We Like It:
Another biotech that looks attractive is BIIB. The sector is breaking out higher and helping lead the way is BIIB, which has been a consistent performer. The stock appears to be launching into a new leg upward after testing support near $65. We're suggesting call positions now with a stop loss under support. There is potential resistance near $70.00 but we're going to aim for the $72.40-72.50 range. The P&F chart points to an $86 target. Part of our challenge is time. We do not want to hold over the October 23rd earnings report.

Suggested Options:
We are suggesting the November calls.

BUY CALL NOV 65.00 IHD-KM open interest=285 current ask $5.10
BUY CALL NOV 70.00 IHD-KN open interest=739 current ask $2.50

Picked on October 07 at $ 67.63
Change since picked: + 0.00
Earnings Date 10/23/07 (confirmed)
Average Daily Volume = 4.4 million


Kohl's - KSS - close: 61.17 change: +2.24 stop: 57.90

Company Description:
Based in Menomonee Falls, Wis., Kohl's is a family-focused, value-oriented specialty department store offering moderately priced, exclusive and national brand apparel, shoes, accessories, beauty and home products in an exciting shopping environment. By the end of November, Kohl's will operate 929 stores in 47 states.
(source: company press release or website)

Why We Like It:
Retail stocks have rebounded sharply. It appears that investors are choosing to ignore all the warnings about a dismal holiday shopping season ahead of us. Now, with the current October bounce, shares of KSS look poised to breakout from an inverse or bullish version of a head-and-shoulders pattern. We're suggesting a trigger to buy calls at $62.01. More aggressive traders might want to jump in early right now. If we are triggered at $62.01 our target is the $67.00-68.00 range. Keep a wary eye on the 100-dma as potential overhead resistance. We do not want to hold over the November earnings report.

Suggested Options:
We are suggesting the November calls. Our suggested trigger to open positions is at $62.01.

BUY CALL NOV 60.00 KSS-KL open interest=6254 current ask $4.10
BUY CALL NOV 65.00 KSS-KM open interest=1888 current ask $1.80

Picked on October xx at $ xx.xx <-- see TRIGGER
Change since picked: + 0.00
Earnings Date 11/15/07 (unconfirmed)
Average Daily Volume = 5.9 million

New Puts

None today.

New Strangles

None today.

Play Updates

In Play Updates and Reviews

Call Updates

Broadcom - BRCM - cls: 37.30 change: +0.70 stop: 34.95

The broad market rally allowed the semiconductor sector to rise about 1%. Shares of BRCM managed to out perform its peers with a 1.9% gain. The stock has rallied back toward significant resistance near $37.50. Friday's move combined with Thursday's intraday rebound has repaired some of the short-term technical indicators. We are still cautious on the stock and would hesitate to open new positions here but technically a move over $37.50 would be a new entry point. More conservative traders could tighten their stops even further. Our BRCM target is the $39.85-40.00 range. The Point & Figure chart is bullish with a $49 target. We do not want to hold over the October 23rd earnings report.

Suggested Options:
If you choose to buy a breakout over $37.50 we'd use the November calls. Keep in mind that we want to exit ahead of the October 23rd earnings report.

Picked on September 12 at $ 35.85
Change since picked: + 0.75
Earnings Date 10/23/07 (confirmed)
Average Daily Volume = 11.0 million


Citigroup - C - clos: 48.30 change: +0.67 stop: 45.79

You wouldn't know it from looking at Citigroup's chart but banking stocks had a pretty good week. The BIX banking index posted five gains in a row. Shares of C did not have a bad week but most of the gains all came on Monday morning and then Friday after the jobs report. Citigroup acts like it wants to go higher but the stock is facing a trend of lower highs and resistance near $49.00. Meanwhile the rally in the BIX index stopped cold near technical resistance at its 100-dma. We are cautiously optimistic on C but readers will want to strongly consider using a tighter (higher) stop loss. Our initial target is the $49.85-50.00 range. Please note that we do not want to hold over the October 19th earnings report.

Suggested Options:
We have two weeks left until C's earnings report. If you choose to open new positions we'd pick the November calls.

Picked on September 16 at $ 46.64
Change since picked: + 1.66
Earnings Date 10/19/07 (confirmed)
Average Daily Volume = 40.7 million


Ceradyne - CRDN - cls: 78.05 change: +0.16 stop: 73.95 *new*

CRDN tagged a new two-month high on Friday but overall gains were anemic thanks to some under performance in the defense sector. Bulls can blame a sell-off in shares of Boeing (BA) for weighing on the group. The general trend in CRDN is still bullish and the stock is within striking distance of our target. Please note that we're adjusting our stop loss to $73.95. Our short-term target is the $79.50-80.00 range. The P&F chart is bullish with a $92 target.

Suggested Options:
We are not suggesting new positions in CRDN at this time.

Picked on September 25 at $ 74.61
Change since picked: + 3.40
Earnings Date 11/01/07 (unconfirmed)
Average Daily Volume = 653 thousand


Deutsche Bank - DB - cls: 135.16 chg: +0.10 stop: 128.99 *new*

Shares of DB have spent the last three sessions trading sideways in a two-dollar range following the Wednesday morning gap higher. The general trend still looks like DB has turned the corner into a new bullish pattern but short-term the stock looks like it may need to correct or digest last week's gains. We would watch for a dip back to $132 or the $130 region as a new bullish entry point. Please note that we are adjusting our stop loss to $128.99. There is potential resistance at the 200-dma near $138.70 so we're targeting a rally into the $138.00-140.00 range. The P&F chart is bullish with a $154 target.

Suggested Options:
If DB provides another entry point we would use the November calls.

Picked on October 01 at $130.79
Change since picked: + 4.37
Earnings Date 10/31/07 (unconfirmed)
Average Daily Volume = 633 thousand


Intl. Bus. Mach.- IBM - cls: 116.30 chg: +0.61 stop: 114.49 *new*

IBM has been under performing the tech sector all week but the stock is still holding above support near $115 and its rising 50-dma. We are inching up our stop loss to $114.49. A rebound from current levels near $116 could be used as a new bullish entry point but keep in mind that IBM has significant resistance in the $118-119-120 region. Furthermore it looks like IBM is due to report earnings in less than two weeks. The stock has already hit our first target in the $118-120 range. Our second, more-aggressive target is the $124.00-125.00 zone. FYI: The Point & Figure is very bullish with a $177 target. We do not want to hold over the mid October earnings report.

Suggested Options:
We would hesitate to open new positions in IBM at this time.

Picked on August 26 at $113.24
Change since picked: + 3.06
Earnings Date 10/17/07 (unconfirmed)
Average Daily Volume = 9.5 million


L-3 Comm. - LLL - cls: 104.74 chg: +0.33 stop: 99.49 *new*

Weakness in shares of Boeing (BA) slowed the rally in defense stocks on Friday. Yet that didn't stop shares of LLL from closing near all-time highs. LLL looks poised to breakout higher after a week's worth of consolidating sideways. Readers looking for a new entry point might want to consider buying calls on a rise past Friday's high near $105.07. An alternative entry point would be a bounce near its rising 10-dma. If you launch new plays this week we would suggest aiming for the $110 region or above. Our target is the $107.50-110.00 range. More aggressive traders may want to aim higher. The P&F chart points to a $115 target. Please note that we're adjusting our stop loss to $99.49.

Suggested Options:
We would suggest the November calls on LLL.

Picked on September 25 at $100.96
Change since picked: + 3.78
Earnings Date 10/25/07 (confirmed)
Average Daily Volume = 904 thousand


Martin Marietta - MLM - cls: 142.61 chg: +1.43 stop: 134.85

MLM continued to rebound on Friday and posted a 1% gain but shares remain under potential resistance at its 100-dma. We remain positive on the stock given last week's bullish breakout from a two-month consolidation/bottoming pattern. We are still suggesting new positions here or on another dip near $140. More conservative traders might want to consider a tighter stop loss. The P&F chart now points to a $170 target. We have two targets. Our first target is the $149.00-150.00 range. Our second target is the $157.00-160.00 zone. We do not want to hold over the late October earnings report.

Suggested Options:
We would suggest the November calls.

Picked on October 02 at $141.31
Change since picked: +1. 30
Earnings Date 10/31/07 (unconfirmed)
Average Daily Volume = 1.0 million


Stryker - SYK - cls: 73.14 change: +0.54 stop: 68.49 *new*

Last week was very bullish for SYK. The stock finally broke out over very significant resistance in the $70.0-70.50 region. Shares of SYK hit a string of all-time highs. While we remain very bullish on SYK we're not suggesting new positions at current levels. Wait and watch for a dip into the $71-70 zone. Broken resistance should now act as new support. We are adjusting our stop loss to $68.49. Our target is the $74.90-75.00 range. It would be tempting to aim higher, maybe the $77.50-80.00 range, but we don't have much time. SYK is due to report earnings on October 17th and we do not want to hold over the report. FYI: The P&F chart is bullish with an $83 target.

Suggested Options:
We are not suggesting new positions in SYK at this time.

Picked on October 02 at $ 70.65
Change since picked: + 2.49
Earnings Date 10/17/07 (confirmed)
Average Daily Volume = 1.4 million


Terex - TEX - cls: 86.41 change: +0.38 stop: 83.75 *new*

Thursday's intraday bounce in TEX looked like a new bullish entry point to buy calls but Friday's follow through has us worried. The stock struggled with the $87.50 level almost all day on Friday. Meanwhile last week's consolidation has put a worrisome tilt in the MACD indicator. We would either wait for another dip and bounce near $84.00, which is short-term support, or wait for a new rise past $87.55. Please note that we're adjusting our stop loss to $83.75. The P&F chart is very bullish with a $100 target. Our target is the $94-95 range although more conservative traders may want to exit near $91.00.

Suggested Options:
If TEX provides a new entry point we would suggest the November calls.

Picked on September 25 at $ 86.50
Change since picked: - 0.09
Earnings Date 10/25/07 (unconfirmed)
Average Daily Volume = 1.8 million

Put Updates

IDEXX Labs - IDXX - cls: 112.40 change: -0.06 stop: 113.85

Our aggressive, high-risk play in IDXX is still in jeopardy. The stock continued to bounce on Friday morning but eventually running into resistance near $113.50 before rolling over. This may prove to be the sort of failed rally we've been looking for as a new entry point for puts. However, at this time, we'd probably wait for a new decline under $111 or $110 before initiating new positions. Our target is the $101.00-100.00 range. We do not want to hold over the late October earnings report.

Suggested Options:
If you choose to open new positions we would suggest the November puts.

Picked on September 30 at $109.59
Change since picked: + 2.90
Earnings Date 10/27/07 (unconfirmed)
Average Daily Volume = 210 thousand

Strangle Updates

(What is a strangle? It's when a trader buys an out-of-the-money (OTM) call and an OTM put on the same stock. The strategy is neutral. You do not care what direction the stock moves as long as the move is big enough to make your investment profitable.)


Dow Jones Industrial Avg. - DJX - cls: 140.66 chg: +0.92 stop: n/a

The rally in the DJIA pushed the October $137 calls toward $4.50 again. We have two weeks left before October options expire. If the DJIA can rally another 150-200 points then our strangle might hit our target. We are not suggesting new positions on the October version of our strangle. The options listed for our October strangle were the October $137 calls (DJY-JG) and the October $132 puts (DJW-VB) with an estimated cost of $4.75. We want to sell if either option hits $6.75.

Suggested Options:
We are not suggesting new positions at this time.

Picked on September 16 at $134.43
Change since picked: + 6.23
Earnings Date 00/00/00
Average Daily Volume = million

Dropped Calls

Whole Foods - WFMI - cls: 53.20 change: +2.12 stop: 46.26

Target achieved again. The rally in WFMI continued on Friday as shares posted a 4.15% gain. The stock was able to breakout to new relative highs. Our first target was the $49.75-50.00 range. WFMI hit our second target on Friday in the $52.50-55.00 range.

Picked on September 26 at $ 46.26
Change since picked: + 6.94
Earnings Date 11/01/07 (unconfirmed)
Average Daily Volume = 3.2 million

Dropped Puts


Dropped Strangles


Trader's Corner

What Are You Implying?

Micron Technology (MU) was due to report Tuesday, October 2. Since dropping to a summer low of $10.30 on August 16, MU had mostly traded in a $1.50 range, but you expected more movement after earnings.

Why? For one reason, the SOX had been trading in a triangle during that same period, and that triangle was narrowing to its apex. It had to break some direction or other soon, and you figured MU's earnings might just be the impetus that would break it. MU was rising just under its 50-sma, and earnings might either break prices above it or roll them down under it.

MU didn't announce the time of day when earnings would be released on Tuesday. It could have been before the market opened, after it closed or any time in between. You decided to buy an ATM straddle sometime Monday, October 1 to take advantage of the price movement you expected. The ATM front-month (October) options were cheap, under a dollar each, so you wouldn't be spending much per straddle contract.

October Options Chain for MU, from CBOE.com:

Although it might be difficult to discern from this snapped image, it looks as if shortly before noon on Monday, October 1, with MU at $11.28, purchasing an Oct 11 call and put would have cost you about $105.00. I'm being conservative in the estimate here, not splitting the bid/ask down the middle but rather shaving only a nickel off the ask for the combined position. Perhaps an astute trader could have gotten into the straddle for a little less.

You think MU should move big enough either direction to give you a profit on the combined position. You sit back, satisfied. This was a good idea, right, this potential earnings play? Maybe.

Maybe not.

You're leaving out something. Two somethings, actually, including a consideration of whether you should have bought front-month or back-month options. The consideration this article addresses is a different one, however. What are the implied and historical volatilities on this day before earnings? Are they far apart? If so, and if the implied volatility reverts to a value closer to the historical volatility after earnings are released, what's going to happen to your straddle?

Before we go further, it's time to talk about historical and implied volatility. Historical volatility is determined by measuring how much an underlying has moved, its actual trading history, over a period of time. According to the great Larry McMillan in his book, TRADING OPTIONS AS A STRATEGIC INVESTMENT, it is "[g]enerally measured by the annual standard deviation of the daily price changes" in the underlying. According to Dan Passarelli, a presenter of CBOE webinars, it's "the annualized standard deviation of daily returns," just a different way of saying the same thing. In other words, it's based on a mathematical manipulation of past actions of the stock.

You don't have to understand how to calculate it. You do need to have these general understandings: it's based on the actual movements of a stock, index or other underlying; it's based on what happened in the past; and underlyings with higher historical volatilities tend to move around a lot more than underlyings with low historical volatilities.

On October 2, my broker listed MO's historical volatility at 13.24 and FFIV's at 46.27. Logic tells you that MO's daily chart would be the one dotted with a bunch of small-bodied daily candles while FFIV's would be dashed with larger-bodied green and red candles. FFIV has, over the last year, proven more volatile than MO.

Implied volatility isn't based on anything that's happened in the past. McMillan terms it a prediction of where the stock price might go, with that prediction based on option prices at any one time. Passarelli calls it the market's consensus of volatility in the future. It's the value that's used in the option pricing model to give a theoretical price for an option. If you've never seen one, options pricing calculators such as the one on ivolatility.com require inputs that include a value for implied volatility.

You can go both ways with the calculator. If you know the price of an option, you can figure out what the implied volatility is. If you want to figure out a theoretical value for an option if the implied volatility were to move to a certain level, you can input that implied volatility and crank out a theoretical value for the option. Of course, the calculators require other inputs, but this is the one that concerns us with this article.

Because historical volatility measures actual movements of the stock and is based on those movements, and implied volatility provides an estimate of future stock action and is based on options prices (or, conversely, determines them), implied volatility sometimes moves far above or below historical volatility. Some traders believe that implied volatility will eventually revert to the mean, or move back closer to historical volatility.

That's the background, a brief refresher on historical and implied volatilities. At the same time the first chart on MU was snapped, my broker pegged MU's historical volatility at 35.29, with the historical volatility drifting down into earnings, as sometimes happens. Traders often don't want to take new stock positions just before earnings, so the historical volatility drifts down. Instead, they may be buying and selling options, either to hedge their stock positions or to engage in a speculative straddle of the type you've just entered in this hypothetical case. Implied volatility tends to go up before earnings as traders buy options, speculating that the stock may move after earnings.

Here's the chart Brokersxpress displayed on October 1, at about noon.

MU's 12-Month Volatility Chart:

Again, it may be difficult to discern from this chart, but the implied volatility stood at about 43. What would happen, then if MU's stock price moved but that IV reverted to the historical volatility's value, dropping into the mid 30's?

Brokersxpress includes a "pricer" function that lets traders calculate just such changes. Let's imagine that by Thursday, October 3, MU had moved up to 13.00, but the IV had dropped to 35.50, closer to the historical value. The pricer returns the following values:

OCT 11.00 Call theoretical value: $2.03
OCT 11.00 Put theoretical value: $0.00

That's pretty good. You'd make money, although may not as much as you'd hoped, particularly after you paid commissions to open and close the position.

What if MU climbed only to $12.00?

OCT 11.00 Call theoretical value: $1.07
OCT 11.00 Put theoretical value: $0.05

Uh, oh. You admit that the gains in stock price haven't been big, but maybe that's still not quite the result you hoped to see, given that you're going to have to pay commissions both ways, to establish the straddle and to sell it to close. You have to consider, too, that this is the optimal pricing, and that the market maker is going to probably want to pay you less than that. MU has moved but you haven't benefited.

What if MU dropped to $10.00?

OCT 11.00 Call theoretical value: $0.04
OCT 11.00 Put theoretical value: $1.02

Again, that's far from what you expected, with MU theoretically dropping $1.28 from the price you'd paid two days earlier, before earnings. This, too, is the optimal, theoretical price, which you're probably not going to be able to get when you sell the straddle, and it's only about a penny above the price you paid for the straddle without even considering all those commissions.

Obviously, with both time decay and a declining implied volatility working against you, you're going to need a big percentage move in MU to benefit from that straddle. A cheap strategy might not equate to a good one.

So what actually happened? A sell-the-numbers reaction occurred. Shortly before 1:00 EST on October 3, MU was at $10.60, $1.19 below the previous day's close and $0.68 below the level at which you purchased the straddle. So, there was some movement, albeit slight, but you already know from the calculations above that the action might not be good for your straddle. The news was going to be worse than anticipated, though.

October Options Chain Snapped at 12:50 on October 3:

From this chain, we can see that the OCT 11 call was $0.15 x $0.20 and the put, $0.55 x $0.60. Lucky traders might be able to sell that straddle for $75.00 ($0.75 combined for the call and put x 100 multiplier), but many will recoup only $70.00 of their original $105 cost. Commissions would need to be paid both directions, too.

Not so good. Obviously, the implied volatility had dropped closer to the historical volatility. You were the victim of a reversion to the mean on implied volatility.

Perhaps as you study other reporting periods, you also notice something that I did: although MU sometimes moves big after an earnings report, sometimes it doesn't. Maybe one could conclude ahead of time that a pre-earnings straddle wouldn't be a great tactic for MU, no matter how cheap the strategy.

The lesson? Before you jump into a straddle the day before an earnings report, the outcome of an FDA application or the release of an important new product, check to see whether implied volatility has jumped way above historical volatility. Check to see whether the stock or index's price movements after such events have been large enough to overcome the deleterious effect on options prices when implied volatility reverts to a level closer to historical volatility. Otherwise, you might be throwing away the money you spent on that cheap straddle. You might find that a different options strategy would serve you better.

Just a note: In case you were thinking that holding out a bit longer might have worked, MU was last trading at $10.80 as this report was edited on Friday afternoon. The OCT 11 call was 0.20 x 0.25, and the put, $0.40 x 0.45. The straddle wouldn't have benefited from waiting.

Today's Newsletter Notes: Market Wrap by Jim Brown, Trader's Corner by Linda Piazza, and all other plays and content by the Option Investor staff.


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