Arcángel de Jesús Montoya
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Arcángel de Jesús Montoya in Money Trafficking,

AIG's Options Are Too Cheap Pre-Earnings

American International Group, Inc. (AIG) is an insurance company. The company provides a range of property casualty insurance, life insurance, retirement products, mortgage insurance and other financial services to customers in over 100 countries and jurisdictions. It is reporting earnings on Tuesday, August 2, at market close:

(Source: TD Waterhouse)

As evident from the above, the company beat earnings estimates in 50% of time in the last eight quarters, underperforming or the rest of time, and has seen modest volatility in the market price of its stock over the last three months:

The market participants expect the following numbers over the next few quarters, including the upcoming one:

(Source: TD Waterhouse)

On the other hand, market data show that the August options are relatively inexpensive:

(Source: TD Waterhouse)

The monthly straddles (options with a strike price of $54.00) are worth around 4.2% of the current market price of the stock. Historically, the stock has been more volatile than that on a monthly basis over the last year:

(Source: Google Finance. Calculations by author)

As you can see, the stock has had a monthly standard deviation of 6.9% over the last 52 weeks, while the straddle expiring in a bit less than a month has an implied monthly volatility of around 5.7% (calculated based on 14 business days remaining until expiration), also including volatility from the earnings event this week. I therefore see signs of modest undervaluation in these options. Hence, buying the straddle is a good idea from the theoretical standpoint.

Investors can also be interested in selling out-of-money options to partially fund straddles:

(Source: optionsprofitcalculator.com)

On the one hand, this will limit expected returns. On the other hand, this action will minimize losses in the event the stock does not move swiftly over the next three weeks. The risk-return profile of this trade looks like this:

(Source: optionsprofitcalculator.com)

What do you think of this trade?