Saturday, February 10, 2007

MA - Mastercard Inc Cl A - A Losing Trade

Dear fellow options traders :

MA (Mastercard Inc Cl A) gapped up about $7.00 when it reported a stellar 3rd quarter earnings on 1 Nov 2006.

Thus, naturally there would be high expectations build up towards the 4th quarter earnings reporting on 9 Feb 2007. Since Jan 2007 till 9 Feb 2007, MA has risen about $10.00 to close at $111.90 on 7 Feb 2007. On 8 Feb 2007, eve of earnings announcement, MA even spiked up about $2.70 to close at $114.74 apparently on the optimisim that MA would topped consensus earnings figures again. High expectations were so built up towards MA's earnings announcement that the options were expensive.

I paper-traded a Feb 110 Put for about $320 on 8 Feb 2007, eve of earnings announcement, when the stock price was hovering around $114.00. The put contract was already out-the-money by $4.00 and I still have to pay a time-value premium for a Feb 110 Put for $3.20!! This means that the stock has to drop beyond $7.20 before my put option would turn profitable. The put option is simply too expensive with the built-up in implied volatility leading towards the earnings announcement. This is an important factor that options traders have to take note when deciding whether to trade such an expensive option for earnings announcement - is the risk/reward ratio worth it?

On 9 Feb 2007 before-market-opened, MA did report a good 4th quarter's earnings as expected. MA earned $0.31 per share, excluding non-recurring items, $0.16 better than the Reuters Estimates consensus of $0.15. Revenues rose 17.2% year/year to $839 mln vs the $821.5 mln consensus. But since expectations have already been built into a good earnings quarter, MA dropped very quickly after market opened, plunging to -$7.80 to $106.80 by 10.19am EST, athough during pre-market trading MA went up about +$4.00.

I sold my put option when MA hit $108.60 around 10.00am EST. Although it has dropped more than $6.00 by that time, I still lose money (about $19.00 including commission) because as I've mentioned earlier, the option was already very expensive when MA need to drop beyond $7.20 before I could make money. MA did fall further from 10.15am EST onwards but I exited my trade earlier because I realised that the buyer side of the Level 2 Code was slowly gaining strength around 10.00am EST.

After MA earnings conference call, Prudential believed that overall, they did not find any indication in either 4th quarter results or management's commentary that would lead them to have any concerns about future earnings growth. This might be a good indication that come next earnings quarter when investors generally have low expectation, MA might gap up nicely if it report yet another stellar earnings quarter.

On 9 Feb 2007, MA closed at -$11.14 to $103.60.

Yours Truly,

Tony Chai