Saturday, August 1, 2009

Options Action - PG Earnings

Friday's Options Action included a preview of the upcoming earnings on Proctor and Gamble. PG, the 4th largest weighted company in the S&P 500 Index and big dog within the consumer staples sector, reports earnings this Wednesday August 5th (not sure if it's pre or post market). Let's take a gander at its volatility characteristics then break down two different strategies thrown out by the Options Action pundits.

A chart review of the reaction to the last 3 earnings announcement shows that PG hasn't moved that much after recent announcements (click to enlarge).

[Source: EduTrader]

Not surprisingly, realized vol on PG has been imploding over the last few months. For you adrenaline junkies out there, PG probably isn't on your radar as it isn't really a mover and a shaker. Current 30 day HV sits at 18%, 10 day HV around 13%. As is usually the case, with Implied vol around 25%, the options board is pricing in an uptick in volatility going into the earnings announcement.

[Source: IVolatility]

Despite the current premium of IV over HV, the two strategies highlighted on options action were both long volatility trades. One pundit mentioned that he usually looks to sell volatility going into a catalyst because options are generally overpriced (I agree). However, he then asserted that, "premium in this name is incredibly cheap already." Now let's put the word "cheap" into context. We've already illustrated that IV is not cheap relative to recent realized vol (e.g. 30 or 10 day HV). Matter of fact it seems on the expensive side. However it is fair to say that due to IV imploding over the last 6 months it is cheap relative to where it has been over the last year or so.

Which is the better comparison?

Hard to say, but I tend to put more emphasis on comparing IV to what's going on right here right now. So I'd say PG options aren't really "increadibly cheap" when seen with the recent market volatility backdrop. Consequently, I'm not convince that options are a slam dunk buy here.
Let's delve into the details:

Calendar Spread:
Buy September 57.50 call for $1.00 and simultaneously sell an Aug 57.50 call option for $.50.
Net Debit = $.50
[Source: EduTrader]

As you can see, the profit zone ranges between about $55.50 and $60. From a directional standpoint the calendar spread is a neutral to bullish bet.

Strangle:
The next recommendation was to enter a long Aug strangle by purchasing the 55 put for $1.15 and 57.50 call for $.50.
Net Debit = $1.65
[Source: EduTrader]

The profit/loss zone is almost the inverse of the calendar spread. At expiration PG has to either be above $59.15 or below $53.35.

Both trades are long Vega, meaning that they profit from a rise in implied volatility. This is quite intuitive as both pundits agreed that PG options seemed on the cheap side. The one big difference between the two trades is the strangle is a long gamma/negative theta trade and the calendar is a short gamma/positive theta trade. If you're expecting a huge move out of PG earnings and want to get long gamma, well I'd take the strangle. If on the other hand you don't anticipate a large move and are looking for PG to drift sideways to up into Aug expiration, I'd take the calendar.

For more info on the relationship between gamma and theta, take a look at Clash of the Greeks Part I and Part II.