Saturday, January 26, 2008

A Credit Spread on Apple Inc. (AAPL)

Dear fellow options traders,

I remember when I started out trading options in 2005 based on earnings gapping, the options premium were not as expensive as of today. The stock options premium could be inflated due to a few reasons, but one of them would be high implied volatility. If a company's share price has been gapping exponentially after earnings announcement for a few consecutive quarters, the market makers would normally priced in this gapping range into the options premium, thus injecting high implied volatility into the premium.

As you might have already known, if you intend to trade a straight call or put option for earnings gapping, you must first predict the anticipated direction correctly, no excuse about that. Secondly, you must pray that the gapping magnitude/scale of the stock price right after company's earnings announcement would be large enough to cover the collapse of implied volatility of the options premium right after earnings announcement. I guess if you have been a premium subscriber of, you would have noticed a news alert entitled "OPTNX Unusual Options Activity" where it would inform you that volatility have decreased for certain stocks which have just reported earnings. So, do remember that options premium price would usually fall right after earnings announcement, due to implied volatility collapse.

But I would definitely discourage you from doing naked options selling even though these options might be a few strike out-the-money (OTM). Although it might seem lucrative to naked sell an option to take advantage of the collapse in implied volatility right after earnings in the hope to buy back the option cheaper afterwards, you would undoubtedly be exposed to unlimited risks! It is especially risky if you're selling naked call options since a company's share price could rise infinitely after a particular event.

Thus this time round, I decided to use a credit spread to trade Apple Inc. (ticker : AAPL) earnings announcement. I've done my research and felt that Apple Inc. should be able to beat Q1 earnings and as usual they should be once again issued conservative guidance for Q2 just like the previous few quarters.

As mentioned earlier, stock options for companies reporting earnings were getting costly and options for Apple Inc. (ticker : AAPL) were no exception. Thus, on 22 Jan 2008, I set up a paper trade bull put credit spread of selling 1 no. of Feb 145 put and buying 1 no. of Feb 140 put for a credit of around $165.00 when AAPL was still trading around $156.00, meaning that the Feb 145 put option that I've sold was a whopping $11.00 out-the-money.

So why a credit spread? You may ask. Well, due to high implied volatility of AAPL stock options, the options premium that could be collected were still attractive although they were a few strikes away. Secondly, the credit spread strategy would be less risky compared to a straight option position since it has 3 situations where it could make money :

1) if the share price went up
2) if the share price stay the same
3) if share price only drop a little

However, if the share price dropped a lot, my credit spread ie. bull put spread would lose money, the maximum loss being the difference of the strike price ie. $500.00 and of course the commissions for setting up the credit spread.

On 22 Jan 2008, Apple Inc. (ticker : AAPL) reported Q1 earnings of $1.76 per share, $0.14 better than consensus of $1.62; revenues rose 35.0% year/year to $9.61 bln vs the $9.47 bln consensus. As expected, the company issued downside guidance for Q2, expecting EPS of $0.94 vs. $1.09 consensus; while Q2 revenues were expected to be 6.8 bln vs. $6.98 bln consensus. But the market reacted negatively to the shortfall in iPod shipments, where the company registered 22.1 mln units vs ~25 mln units street expectation.

On 23 Jan 2008 when market opened, Apple Inc. gapped down by almost -$17.00 to $136.20. As mentioned earlier, my bull put credit spread would lose money if the share price dropped a lot. Thus, I was prepared to lose money in the position. But I understand that if Apple Inc. (ticker : AAPL) share price could go up intra-day, I might be able to close the position with a smaller loss.

Thus, I monitored the stock chart and Level 2 code carefully but once I saw that AAPL has difficulty moving up, I close the position by buying back the Feb 145 put and sold off the Feb 140 put for a loss of $174.00 (The $165.00 credit that I've received earlier for setting up the position helped defray some of the loses).

If I would have bought a straight Feb 165 call which cost $810.00 per contract when AAPL was trading around $155.00, where the call option was almost $10.00 out-the-money but still costs $810.00 per contract, I would have lost more money compared to the credit spread that I had set up.

Thus, in way, the credit spread has helped minimize the loss of more capital if you had committed it in a straight option position in this situation. I hope this would provide you an alternative idea if you intend to trade earnings gapping next time.

Yours Truly,

Tony Chai
Options Trading Resources

Note : On 22 Jan 2008, the Dow Jones Future plunged more than 500 points. The U.S. Federal Reserve quickly moved in to cut a un-precedented 75 basis points to the interest rate in an effort to revive the market. On 23 Jan 2008, the Dow Jones Industrial Average sank as much as 323 points before bouncing back to rise 298.98 points, or 2.5 percent, to 12,270.17.

Saturday, January 19, 2008

A Trade on Genentech Inc (DNA)

Dear fellow options traders :

Noted that Genentech Inc (ticker : DNA), a major pharmaceutical/biotech company which research and market mainly oncology drugs, would be reporting earnings on 14 Jan 2008 (Monday) after-market-closed (AMC).

Pharmaceutical companies seldom gapped up or down dramatically after earnings announcement. Their price gapping action derives mainly from FDA decisions on their Phase III clinical trials or New Drug Approval (NDA) applications, but that's another big topic altogether. But there were occasional exception to this instances though...

1) Amgen Inc (ticker : AMGN) : On 20 July 2005, AMGN gapped up +$7.00 to $77.51 and went up intra-day another +$4.00 to close at $81.17 when this biotech company's Q2 earnings-per-share (EPS) beat consensus by $0.16 and revenues rose 22.7% year/year to $3.17 bln. The company also issued upside guidance for FY05.

2) Invitrogen Corp (ticker : IVGN) : This biotech company makes and markets research tools in reagent, kit, and applications forms for the life sciences research, drug discovery, and diagnostics customers, as well as biological products manufacturers. It has good price gapping habit after earnings announcement in the past few quarters. I would share with my opt-in subscribers about the gapping behavior of this company when they report Q4 earnings sometime in Feb 2008.

Then why do I want to trade an option on Genentech Inc (DNA) since it has not much gapping action for earnings, you may ask.

Well, what caught my attention was that this company's share price went up +$5.00 to $71.50 for past few days before earnings announcement without really "fantastic" news. In fact, some comments from the research analysts were somewhat "conflicting". For example, I've read one of the following...

"We remain bullish on DNA's performance, adjusting their estimates, but remaining above consensus. Due to lower than expected script trends,we reduce their revenue ests for 4Q07 to $3.03 bln from $3.04 bln, slightly above the Street estimate of $2.93 bln. For the quarter we expect non-GAAP EPS of $0.70, three cents above consensus at $0.67. We have observed a continued reduction in Lucentis use, and speculate that this is due to cannibalization from off-label Avastin use. Based on available script data, we do not expect to see an appreciable impact of the recent ODAC meeting on the use of Avastin factoring into fourth quarter numbers."

I don't know whether you understand the above but to me the comments were neither positive nor negative. I felt that if DNA couldn't report a spectacular Q4 earnings on 14 Jan 2008 AMC, the earlier $5.00 rise in stock price earlier might not be justifiable and the stock price might suffer after earnings announcement.

On eve of DNA's earnings announcement ie. 14 Jan 2008, when I saw the support price level of $71.80 was broken, I bought a just-out-the-money Jan 70 put contract for about $55.00 per contract.

As I monitored that the stock price kept breaking down intra-day and that I've researched that DNA didn't gap much for previous earnings announcement, I set a stop loss for the position to be closed if the bid price hit $1.00 (I bought at the limit price of $0.55). The bid price was hit intra-day and I gained a profit of $45.00 (excluding commissions).

On 14 Jan 2008 AMC, Genentech Inc (DNA) reported Q4 earnings of $0.69 per share, $0.02 better than the $0.67; revenues rose 9.4% year/year to $2.97 bln vs the $2.97 bln consensus. The company only issued in-line guidance for FY08 The company also reported revenue of some of their companies' drugs which fell short of the consensus numbers.

On 15 Jan 2008 when market opened, DNA gapped down -$1.20 to $68.50. I could have sold the option position at a slightly higher price if I'd held on but I was contented I was able to get out of the position with a small profit. It also show that this company did not have much gapping price movement for earnings announcement.

Yours Truly,

Tony Chai
Options Trading Resources

Note : Lucentis and Avastin are both drugs manufactured by Genentech Inc (DNA)

Saturday, January 05, 2008

A Trade on Bed Bath & Beyond Inc (BBBY)

Dear fellow options traders :

First of all, I want to wish everyone a Prosperous 2008 with your options trading!!

Checked that Bed Bath & Beyond Inc (ticker : BBBY) would be reporting earnings on 3 Jan 2008, after-market-close.

Bed Bath & Beyond Inc operates a retailer chain selling a range of domestic merchandise and home furnishings products. My first thought was naturally geared towards whether the company's business would be affected by the current housing market slump. As we know, the housing market have been hit quite badly for the past 2 years. Investors by now should be fully aware of the fallout of the sub-prime mortgage sector and the alarming rate of mortgage defaults & foreclosure. On 28 Dec 2007, the housing market plunged deeper into despair as it was reported that in Nov 2007, sales of new homes plummeting to their lowest level in more than 12 years, heightening fears that the US might be thrust into a recession. New-home sales tumbled 9% in November 2007 from October 2007 to a seasonally adjusted annual sales pace of 647,000, the worst sales pace since April 1995.

At the same time, I read from a report that BBBY's operating margin has been slumping for the past few quarters. It was also reported that in first six months of Bed Bath's fiscal year 2007, the chain generated just less than $125 million in free cash flow and yet the company went ahead with the share repurchase program.

I've studied that BBBY's past gapping range after earnings was around $2.00. Thus, on 3 Jan 2008, I paper-traded 2 lots of near-the-money Feb '08 27.50 put at $140.00 per contract when BBBY was trading around $27.50.

On 3 Jan 2008 after-market-close, Bed Bath & Beyond Inc (BBBY) reported Q3 earnings of $0.52 per share, which included $8 million tax gain and might not be comparable to the consensus of $0.52; revenues rose 10.9% year/year to $1.8 bln vs the $1.77 bln consensus. But the company issued downside guidance for Q4, expecting EPS to be $0.64-0.67 vs. $0.78 consensus; and would be expecting flat comps for Q4.

On 4 Jan 2008 before market opened trading, the Dow future was already down more than 100 points when disappointing employment data were reported. The December non-farm payrolls came in at only 18K. The economists were expecting payrolls to increase by 70K. The unemployment rate was also at an alarming rate of 5.0%, giving further hint of a possible economy slump. The market didn't react well to BBBY's earnings too, as the stock price gapped down -$2.30 to $25.12 when market opened trading.

I watched the Level 2 code, candle stick chart movement and trading volume and sold the 2 lots of puts for $300.00 a contract when I noticed that the selling pressure (circled in red in the chart) has precipitated. The paper profit was $290.00 after deducting commission.

Yours Truly,

Tony Chai
Options Trading Resources

P.S. BTW, I've just completed an e-book entitled "How To Avoid The 5 Silly Options Trading Mistakes I've Made",which is rather self explanatory on how you could save your hard-earned capital by learning from the money-losing experieces that I have encountered during my options trading journey. You can claim this e-book for FREE by sending an email to Once you're in the mailing list, I would also be sending you emails at time where I would highlight potential stocks for earnings gapping analysis trade for your consideration. So do look out for them :)