How To Pick A Stock To Trade

It’s earnings season so it makes sense to continue looking at earnings trades.  Yesterday,  I was going through the long list of companies announcing earnings last night and this morning.  If they had a skew to the volatility of the options closest to the where the stock was trading I kept them on the list.  That is, if XYZ is near $50 I looked at the May 50 call, say its implied volatility was 90%.  Then June 50 call might have an implied volatility of 80% and the August 50 call an implied volatility of 70% and the Jan 50 call an implied volatility of 70% also.  That would be a skew to the volatility that might be trade-able.

The idea is that 70% is the baseline implied volatility right now so after the uncertainty of earnings is over, the May options would drop to that implied volatility.  Since the implied volatility drops twenty points, that will decrease the value of the options.  So selling a May straddle and protecting oneself with, say an August straddle or a combination of August options would be profitable.

Most of the stocks announcing earnings yesterday didn’t have much of a skew at all.  The ones that did are in the table below.

Bid Ask Spread

The problem with a few of them is that the bid ask spread was too wide as a fraction of the option value.  If one has to buy at $2 and sell at $1.90 the bid ask spread is $0.10.  That is about 5% of the option price.  If one has to buy at $0.50 and sell at $0.40 that same ten cents is now 20% of the option price.  It is harder to make money if the spread is too wide.

That was the problem with AXYS and FITB and ADS (a $0.40 spread on a $6 Sep option).  CIT looked interesting, the possible percent drop in May implied volatility was 28% but CIT was trading at $4 and there were options with strikes at $2.50 and $5.  So I didn’t see how to make it work.

PNC

So I decided the best candidate to trade was PNC Financial Services Group, a bank based in Philadelphia that just bought National City, a Cincinnati bank. Perhaps the uncertainty in its earnings is due to the integration of National City and the evaluation of National City’s book of loans.

Looking at the last thirteen earnings announcements, the range of price movement on the day of the announcement was from -9% to +8%. The at the money straddle was almost 20% of the price of the stock.

So towards the end of trading yesterday I sold the May 40 straddles for $7.75 and bought the August 47.5 call for $3.55 and the August 32.5 put for $4.45. The cost was $0.25 per set of options and commissions.

This morning PNC announced earnings and had their conference call. The stock hasn’t moved much, it closed yesterday at $38.06 and opened this morning at $40.56. The range today so far, it is 12:45 now, is $38.13 – $41.49. So it is within the $7.75 of the straddle. But the volatility of the May options is still in the mid 90s. The August implied volatility is 79 near where it was yesterday.  So now it is a matter of waiting for the May volatility to drop.

To be continued….