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

Sell Cisco System's Overvalued Options Pre-Earnings

Cisco System, Inc. (CSCO) designs and sells lines of products, provides services and delivers integrated solutions to develop and connect networks around the world, building the Internet. The company is engaged in designing, manufacturing and selling Internet Protocol (IP)-based networking and other products related to the communications and information technology (IT) industry, and provides services associated with these products and their use. The company operates its business through three segments: The Americas; Europe, Middle East, and Africa (EMEA), and Asia Pacific, Japan, and China (APJC). It is reporting earnings on Wednesday, August 17, after market close:

As evident from the above, the company beat earnings estimates in 100% of time in the last eight quarters and has seen modest volatility in the market price of its stock over the last three month:


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

(Source: TD Waterhouse)

Market data show that the August options are a bit overvalued:

(Source: TD Waterhouse)

The one-week straddles (options with a strike price of $31.00 and expiring on August 19, 2016) are worth around 3.4% 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 7.2% over the last 52 weeks, while the straddle expiring in a week has an implied monthly volatility of around 2.7% (calculated based on 3 business days remaining until expiration), also including volatility from the earnings event next week. I therefore see signs of modest overvaluation in these options. Hence, selling the straddles is a good idea from a theoretical standpoint.

Investors may also be interested in selling iron condors to capitalize on the above-average implied volatility, while hedging against swift moves in the underlying:

(Source: optionsprofitcalculator.com)

The risk-return profile of this trade looks like this:

(Source: optionsprofitcalculator.com)

As you can see from the above illustration, the "window of safety" is around 8.0%. This means that the stock has to move roughly 4.0% in either direction from the current price by expiration in order for investors to start losing money. The risk-reward ratio of around 1:0.68 is in line with this type of option strategies and is deemed attractive in the case of a low volatility stock like Cisco Inc..