Google Options Overpriced For Earnings

Michael is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Earnings season occurs four times a year and it can be one of the most rewarding but also dangerous times for investors. Only those with a keen sense of risk versus reward can continue to realize success from earnings trades. But more than just proper risk management, the proper strategy must be used as well. And by using options, one can trade earnings the same way that professional volatility traders do.

Before I discuss the actual trade, I want to present a case for why Google (NASDAQ: GOOG) is likely to stay within a trading range for a while.  The company has a lot going for it but also has a few concerns.  

The Positives

1) Google owns approximately 67% of the search market in the United States.  The next closest competitor in that space is Microsoft which owns approximately 15.5%.  Now while this metric is impressive, it is important to note that the percentage is likely to grow in the future as the company finds ways to penetrate new markets globally.  The company has been unable to penetrate China as of yet but should that happen, expect the company to benefit from it.

2) Google's android continues to be the leading smart phone across the globe.  In October, IDC reported that the Android owns a 68% share of the smart phone market.  The next closest competitor is Apple at 17%.  

The Negatives

1) The stock may be slightly ahead of itself in terms of price and valuation.  After a disastrous earnings report last quarter in the middle of October, the company saw itself trading at a 3 month low in mid November at $636 per share.

<img src="/media/images/user_15428/goog_1_large.JPG" />

Since that low, the stock has done nothing but rally and is just about back to where it was before the last earnings report.  So investors need to be wondering whether this is a justified price level considering that the earnings announcement, which will detail how the company has performed over the past 3 months, is just around the corner.

2) Google's PE ratio currently is 23.1, which is on the high side over the past 2 years, as the diagram below indicates.

<img src="/media/images/user_15428/google-pe_large.JPG" />

Now the circled number, 22.57 is where Google was heading into their last earnings report.  Now Google is even higher than that heading into its next earnings report.  That should give investors reason for caution.

Fundamental Conclusion

So it seems that Google has both positives and negatives as it heads into earnings season.  I believe that this will be a battle between bulls and bears for at least a few months.  I think although the company is at a fairly high valuation, the earnings report that comes out will justify that.  And I expect the stock price to stay in a fairly tight trading range.  Now this doesn't leave a lot of room to be made on the long or short side for stock but what about options?  Below I present a case for an option strategy that can be used to profit from Google staying at its current valuation.

The Strategy

When trying to place an earnings trade using options, it is important to look at the current stock price, whether it is near a 52 week high, the relevant at-the-money option straddle price, and historical earnings reactions.  Because Google will be releasing its earnings on Tuesday, Jan. 22, after the market close, we will be using the weekly option markets expiring on Jan. 25.

Google is currently trading at $741.48, up 0.46% on the previous day.

<img src="/media/images/user_15428/goog_2_large.JPG" />

The 52 week high for Google is $774.38 so that is not a concern in this example.  It it was at or near the 52 week high, it is important to understand that an earnings event can cause more volatility than normal as the stock will be under intense pressure to exceed expectations to justify its high price.

Since Google does have the weekly options available, we will take the price of the at-the-money straddle for the weekly options that include the earnings event, which happens to be the options expiring on Jan. 25. The $740 straddle, which includes the $740 call and $740 put, is currently priced at $47.10 mid-market.  You can use this straddle price to determine the expected percentage move on earnings by dividing the straddle price by the stock price.  This mathematical equation comes out to an expected move of 6.4%.  Now that we know the market is anticipating a 6.4% move, we must analyze Google's past reactions to earnings.

Historical Earnings Reactions

In order to determine whether buying or selling the straddle is a wise move, one must look at the historical reactions to earnings and I typically like to look at the past four earnings moves.  However, something unusual happened with Google during the last earnings report on Oct. 18.  The earnings report was inadvertently released during market hours causing extremely volatility and causing the stock price to move a lot more than usual.  So for this analysis, we will exclude the October 2012 report, and use the four earnings events prior.

The average of those moves has been 5.3% as shown below:

  • Earnings Event #1 on July 19, 2012.  Stock increased by 2.8% after the earnings release.
  • Earnings Event #2 on April 12, 2012.  Stock decreased by 4.1% after the earnings release.
  • Earnings Event #3 on January 19, 2012.  Stock decreased by 8.4% after the earnings release.
  • Earnings Event #4 on October 13, 2011.  Stock increased by 5.9% after the earnings release.

The Trade

So the market thinks the stock will move 6.4% after earnings, but the stock has typically only moved about 5.3%.  Additionally, the VIX is approaching its 52 week low of 13.22 meaning that there is overall less volatility in the market which could further diminish the Google reaction.  In this case, I would saying that selling the $740 straddle represents an opportunity to make money since the investor will be receiving more money than the stock is expected to move.

The worst case scenario is that the stock moves a lot more than expected.  This could result in substantial losses if the stock moves more than $47.10.  Our breakevens are $692.90 on the low side and $787.10 on the high side.  We need stock to stay between those two prices and if it does, you will make money on this play.  

Fool blogger Michael Meyer does not own a position in either Google or any of its associated options.  Before trading options, please consult your financial advisor to determine if they are suitable for your level of risk.  The above option strategy is meant for discussion purposes only and is not financial advice.  If you choose to make the trade, please use proper risk management techniques as options can involve a high degree of risk.  Selling options can result in complete loss of value.

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