October 26, 2010

Options Expirations and Earnings Reports

If you want a belly laugh and a breath of fresh air, read John Cochrane’s oped on the treasury secretary in today’s Wall Street Journal.

Speaking of news, a common headline in web news strings for clients is: “Preparing for (fillintheblank’s) Earnings Announcement with an Option Straddle.”

Seen that? Traders wait for companies to say when they’ll report results. They prefer if you do it a few weeks ahead so they can get cheap puts and calls. Just days between your announcement and earnings, and options may be in high demand and limited supply. It’s a lesson, IR professionals, about modern markets.

But before we get to that, let’s talk about these traders tall in the straddle. A straddle means what you think: on both sides of the fence. Traders buy both a put, a right to sell shares, and a call, or the option to buy them. Each such contract represents 100 shares.

Used to be, you didn’t want options near the expiration date. The closer you are to an event, the easier to predict outcomes, and therefore the less the profit opportunity. Three months out, who knows if a stock will be $10 or $15? Five days, it’s easier to tell.

This fact is reflected in the market value of the option. If you buy a right three months out and as expiration approaches it’s apparent that your option is not likely to have value, you can’t unload it on somebody else for even what you paid. That’s time decay.

The hedge against something being worth less tomorrow is a straddle. Let’s make up a simple example. You trade at $10. You send a release saying you’ll report results in three weeks on Nov 18, ahead of expirations on Nov 19. A trader buys a call, the right to buy your stock, for $9. It costs the dollar difference between market and strike prices plus some time value set by the market. Say $1.

Each contract is 100 rights, so the trader pays $200. The trader also buys the opposite right, a put, also for $2, for the right to sell shares at $11. The trader spent $400, the total at risk.

Anytime, things can change the value of the straddle. Say your peer reports great results ahead of you. The call now is more valuable, the put weaker. Maybe the trader chooses to sell the call at a profit and let the put lapse.

The ways derivatives are used affects your liquidity and trading. If the underwriter of the call – say, a bank – is now at risk, the bank may buy shares in anticipation of needing to meet demand, and they may short your stock too, anticipating a drop based on call or swap demand fueling a brief speculative frenzy.

This stuff abounds today. And with high-speed trading in many asset classes and a colossal swaps business reflecting the same thing but in private contracts between parties, the combinations are nearly infinite. While you need not worry about controlling it, you can take steps to help that finite group of fundamental investors tuned to intrinsic value.

Lessons: When possible, avoid giving derivatives speculators a cheap path to profits. If you report after expirations, the time-decay component of an option’s cost will be greater, and the short-term profit opportunity smaller. What’s it hurt to wait three days?

By extension, if you know your results are likely to be spot-on with estimates, you may WANT to report before expirations. The chance to profit from derivatives speculation will be diminished because the expected result may be factored into your share price.

Heck, in a perfect world you’d vary your reporting dates to keep traders guessing – the opposite of the old convention about doing the same thing at the same time. But see, that conventional wisdom springs from when rational money was 50% or more of daily volume, ten years ago. Today it’s about 10%.

Looking cool in the IR chair ain’t what it used to be – but it’s just as cool as ever to be cool.

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