Wednesday, April 16, 2014

Is Options market pricing the risk correctly in Google earnings

Google is scheduled to report 1Q-2014 earnings after the close of trading on Wednesday, April 16th. For the March Quarter, analysts are expecting earnings per share of $6.41 (Range: $6.00 -$6.83). For FY 2014, analysts are expecting revenue of $66.47 billion dollars implying 11.10 percent year over year growth.
For the last 14 quarters, Google's stock has on an average moved 6 percent, next day after the earnings release. Table below presents how the options market has historically priced at-the-money straddle for Google before earnings (in percent terms, standard deviation terms, and the implied volatility levels). Also included in the table is volatility crush that happens in the options after the earnings are released.

Heading into the earnings this week, the risk reflected by the options market (30 and 60 day implied volatility levels) is marginally lower than the all time highs levels seen last week. For the earnings event , options market is expecting a 5.85 percent move, which is close to the average move in the stock for the last 14 quarters. From an implied volatility perspective- ATM straddle seems overpriced, but appears to be priced fairly on an absolute move basis.
Despite missing the consensus sales estimates in seven of the last nine quarterly reports, market has rewarded Google on the hopes of its multiple revenue streams in future. Besides, the strong growth reported by the Internet software and services industry lifted the growth expectations for Google as well. Decomposing Google Price/ Earning ratio reveals the growth premium built in its stock price. Google stock has lost 13 percent after making an all time highs earlier this year. Even at current market price levels future growth accounts for approximately 50 percent of Google's price.
Implied volatility for long-term dated contracts in Google started to rise before the stock became a victim of momentum reversal in the technology sector. Implied through this divergence in volatility regime from the broader market is the magnification of risk in Google' stock beyond an earnings event.

Earnings Trade
I am quiet intrigued by the fact that Google straddle is pricing only average move heading into the earnings this quarter especially when the momentum stocks have taken a sharp beating. In fact market participants have continued to sell the volatility premium in Google's options since the beginning of this week. Even though I tend to view Google as overvalued at current levels but traders need to be cognizant of the irrational price movement which a growth stock can experience - by elevation of expectations only. 
For the above mentioned reasons and current market sentiments , long volatility offers favorable risk reward . Traders should factor in the volatility crush which the options will undergo after the release of earnings. 
I expect a volatility crush of 3.5 points for June options - exposing 515/575 strangle to a $530 dollars risk if Google does not move.  For September options, I expect a volatility crush of 1.5 points - exposing position to a risk of $250 dollars.  Both these positions have asymmetric payout if moves sharp and fast and these time left to expiry also enables to recover the losses as well. 

1 comment:

  1. I am surfing online from more than three hours; however I never found any kind of interesting article like yours one. …. I am new with option trading. Please tell me ways to use the option trading calculator and just how I get the details about "how much call/place it gives today?" means just how much points market gives phone or put. Thank a lot…Thank you...