International Business Machines Corp. (IBM) reports earnings after Tuesday’s bell, and investor anxiety is through the roof. Big Blue ended 2014 as one of the worst performers in the Dow Jones Industrial Average and has done little to right the ship since.
Relative weakness continues to plague the ailing tech behemoth as investors prep themselves for tonight’s fireworks.
Mostly, IBM stock holders are just hoping we don’t see a repeat of the epic downturn following its last earnings announcement in October. Shares of IBM tumbled 8% overnight suffering the largest earnings down-gap in years.
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With the memory of last quarter’s bloodletting still fresh in the minds of investors, it’s no wonder risk in IBM is sky-high right now.
The increased demand for protection heading into IBM earnings has driven the implied volatility for its options to new 52-week highs near 27% (yellow line in the char below). To gauge the expected reaction following earnings, we can use the price of the $155 straddle for January weeklies that expire at the end of the week. At $6.55, the straddle is pricing in a move of about 4.2% by end of day Friday.
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What’s more interesting in IBM options is the heavy volatility skew of out-of-the-money puts versus out-of-the-money calls. With IBM stock at $155, the OTM $145 put is trading with an implied volatility of 29.1%, while the OTM $165 call is only trading with an implied volatility of 22.8%. Investors are really paying up for downside puts, which will only deliver rewards if we see a larger-than-expected drop following earnings.
In light of the elevated risk priced into IBM options, here are two attractive option plays.
Bet With the Vol Skew
If you’re willing to bet traders bidding up OTM puts are smart money and we do indeed see another downturn in IBM following earnings, buy a Feb $155/$150 vertical put spread for $2.10.
By both buying and selling puts, you’ll largely mitigate any volatility exposure and instead have a position that profits directly from a drop in IBM stock. The max loss is $2.10 and will be incurred if IBM is above $155 at expiration. The max gain is $2.90 and will be captured if IBM sits below $150 at expiration.
Bet Against the Vol Skew
If you believe the risk in IBM options is overblown and downside puts are overpriced consider selling a Feb $141/$135 vertical put spread for 55 cents credit. Consider it a bet that IBM remains above $141 for the next month. The max gain is limited to the initial 55 cents credit received. The max loss is $5.45 and will be incurred if IBM sits below $135 at expiration.
As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.
