Forecast came true

Yahoo Will Not Move By More Than 10% (In Total) During The Earnings Week
8 april 2016

Yahoo is reporting earnings in less than two weeks from now (Q1 2016), on April 19, 2016. One may be expecting volatility and looking at buying straddles on order to capitalize on swift moves in the stock price. Well, I have bad news for you - the straddles are overpriced:

(Source: Google Finance)
Note: the options above expire in less than two weeks from now - on April 22nd, 2016.

Based on the current market price of just north of $36, the straddle is worth around 8% - 10% of the underlying (divide the market price of the straddle by the current price of the stock). How do I know that the straddle is overpriced? Well, I have two ways to check that.

First, I will look at historical volatility of the stock:

(Source: Google Finance. Calculations by author)

As you can see, the necessary 10% volatility to break-even on the straddle could be obtained only with monthly straddles. Hence, the two-week straddles are simply too expensive relative to historical volatility.

Secondly, I checked the last eight earnings dates (one week prior and one week after) to see what total price change in the underlying was demonstrated on the market back then:

(Source: TD Waterhouse)

My findings indicate that a 10% move prior or subsequent to the earnings release took place only two times out of eight (25% of time):

(Source: TD Waterhouse. Analysis by author)

As a result, I have established that the straddles are overpriced relative to historical volatility: both overall and during the earnings periods. Hence, if you buy the straddles expiring during the week of April 18, you will likely lose money. On the other hand, I do not recommend selling straddles either because option sellers are exposed to virtually unlimited risk (especially, in the case of the call). Therefore, a strategy like iron condor:

(Source: marketcalls.in)

For example, investors can utilize the following strategy:

(Source: Google Finance. Calculations by author)

The risk-return profile of this trade is as follows:

(Source: optionprofitcalculator.com)

Note: the figures represent profit/loss estimates per 1 option contract (100 shares).

Apparently, this trade offers a 3.6:1 risk-return ratio, which I find extremely attractive for such a short time period. 

What do you think about Yahoo's forthcoming volatility and this trade, in particular?

Answered:
9 people

Yahoo Will Not Move By More Than 10% (In Total) During The Earnings Week

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Forecast came true

Yahoo's stock did not move by over 10% in any time during the last two weeks. In fact, the total return over the two-week period is about 4%. The stock crossed the $38 line a couple of times but closed at $37.48. This means that the owners of the iron condor described in this forecast actually made a small profit on the position (I expected more, oh well!)