This second week of earnings season is a bit unusual, as the pace of reports remains on the slow side. Although fewer than 20 S&P 500 companies will be in line to report, it will contain a few heavyweights, including Intel Corporation (NASDAQ: INTC), JPMorgan Chase & Co. (NYSE: JPM), Google Inc. (NASDAQ: GOOG) and General Electric Company (NYSE: GE).
Let’s take a closer look at Google. The company reports after the close on Thursday, with analysts expecting a 13% gain in profits from a year ago. Last quarter, the company missed the estimate for the first time in eight quarters. So with modest expectations this quarter (compared to recent earnings gains) and a history of beating estimates, you’d think we’d be buying call options.
Not so fast. The problem with GOOG is that it typically runs up into earnings, and then falls sharply after reporting. Take the past three quarters, for example. The shares have dropped an average of 6.7% in just the one day after reporting.
Once again, GOOG is rallying ahead of its report, gaining about 20% since the end of August. The stock is looking overbought and is finding some resistance around the $540 level.
The other thing working against GOOG is sentiment, which is decidedly positive. The put/call ratio is dropping, indicating a recent preference for call options. Short interest is non-existent. And just 1 of 37 covering analysts rates the stock a “sell” compared to 32 “buys.” Not much room for upgrades there.
GOOG options are expensive, if for no other reason than the stock price is high. Right now, an at-the-money GOOG Nov 540 Put would run you about $20-$21, or up to $2,100 per contract.
An alternative strategy is a debit spread, in which you buy the GOOG NOV 540 Put and sell the GOOG Nov 510 Put for a net cost of around $12, or $1,200 per contract. If GOOG drops to $510 (5.5% decline) by November expiration, the 540 put will be worth $30 and the 510 will expire worthless, giving you a 150% profit. That’s the most you can make on the trade, because any larger decline in the stock will cause the 510 option to go into the money, forcing you to buy the option back. But remember that your 540 put will increase in value as well.
Should GOOG spike higher on earnings, you have fewer dollars at risk. Plus, option prices tend to increase as earnings approach due to increased demand. By selling an option, you essentially cancel out that additional cost.
The downside is that a spread limits the trade’s profit potential. But 150% ain’t too bad. So if your budget or risk appetite isn’t big enough for a straight put purchase, try the debit spread.
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