Today I would like to share with you an options investment I made yesterday, just prior to the Apple (AAPL) earnings announcement. While it is too late to make this same investment yourself, you might consider it three months from now when announcement time comes around again, or with another company that you feel good about.

Please continue reading down so you can see how you can come on board as a Terry’s Tips subscriber for no cost at all while enjoying all the benefits that thinkorswim incentive offers to anyone who opens an account with them.

Terry

An AAPL Earnings-Announcement Strategy: Approximately every 90 days, most public companies announce their latest quarterly earnings. Just before the announcement day, things get interesting with option prices. Since stocks often make big moves in either direction once earnings (and other numbers such as gross sales, margins, and future guidance) are announced, option prices get quite expensive, both for puts and for calls.

For people who like to collect high option premiums (i.e., selling expensive options to someone else), this pre-announcement period seems like a great opportunity provided I have a feeling one way or the other about the company. I had a good feeling about AAPL this month. I wasn’t sure what earnings might be (beware of anyone who says he is sure), but I thought the company was fairly priced, and I think the huge stash of cash they are sitting on provides some protection against a large drop in the stock price.

When a situation like this occurs (where I like a company and earnings are about to be announced), one of my favorite strategies is to buy a deep in-the-money call on the company, a call that has a few months of remaining life, and sell an at-the-money call in the shortest-term option series that expires after the announcement day.

On Monday morning, AAPL was trading about $525. I bought a diagonal spread, buying Jan-14 470 calls and selling Nov1-13 525 calls (AAPL has weekly options available, and the Nov1-13 calls would expire on Friday, November 1st , four days after the announcement after the close on Monday.

I paid $62.67 for the Jan-14 470 call and sold the Nov1-13 525 call for $17.28, shelling out a net $45.39 ($4539) for each spread. (Commissions on this trade at thinkorswim were $2.50). The intrinsic value of this spread was $55 (the difference between 525 and 470) which means if the stock moved higher, no matter how high it went, it would always be worth a minimum of $55, or almost $10 above what I paid for it. Since the Jan-14 calls had almost three more months of remaining life than the Nov1-13 calls I sold, they would be worth more (probably at least $5 more) than the intrinsic value when I planned to sell them on Friday.

So I knew that no matter how much the stock were to move higher, I was guaranteed a gain on Friday. If the stock managed to stay right at $525 and the Nov-1 525 call expired worthless (or I had to buy it back for a minimal amount), I stood to gain the entire $17.28 I had collected less a little that the Jan-14 call might decay in four days. A flat market would net me about a 36% gain on my investment, and any higher price for AAPL would result in at least a 25% gain.

After a company makes its announcement, all option prices tend to fall, especially in the shortest-term series that expires just after the announcement. However, deep in-the-money options like the one I bought derive most of their value from being so deep in the money, and they generally do not fall nearly as much as shorter-term, nearer-the-money options.

On the downside, the stock could fall at least $20 before I would incur a loss. Since the delta of the Jan-14 470 call was 80, if the stock fell $20, my long call might fall about $16 ($20 x .80). That would still be less than the $17.28 I collected from the 525 which would expire worthless so I would still make a gain.

Actually, as the stock falls in value, delta for an in-the-money call gets lower, and the Jan-14 call would fall by less than $16. The stock could probably go down at least $25 before I lost money with my original spread.

In the event that AAPL fell over $25 so I lost some money on the spread, since I like the company and it is now trading for only $500, I might want to hang onto my 470 call rather than selling it on Friday. I might sell another 525 (or other strike) call with a few weeks of remaining life, reducing my initial investment by that amount.

I like to make an investment that could make 25% or more in a single week if a company I like stays flat or goes higher by any amount after an announcement, and the stock can fall about 10% and I still make a gain. A more conservative investment would be to sell an in-the-money call rather than an at-the-money call. While the potential maximum gain would be less, you could handle a much greater drop in the stock value before you entered loss territory on the downside.

Two weeks ago I told you about an options investment I made in Google.  This investment was made just before Google was scheduled to announce their earnings for the latest quarter.  For that reason, the October options had skyrocketed in value as they usually do just prior to an announcement, especially the options that will expire shortly after the announcement is made.Google announced earnings after the close on Thursday, October 17th, and the company exceeded expectations by a large margin.  The stock rose over $120 on Friday.

I had made my investment in hopes that it would at least stay flat.  If it did, I would stand to gain about 8% on my investment in only two weeks.  Let’s see how these options did when the stock made such a huge upward swing.

Terry
 
Update on Google Options Purchase:  My original goal was to use call options as a proxy for owning 100 shares of stock.  I discovered that I could buy the equivalent of 100 shares and shell out only $15,500 rather than the $87,000 it would take to buy 100 shares.

As I reported two weeks ago, I bought 2 GOOG 800 calls that expire on the third Friday of January 2014, paying $8600 for each call, or $17,200 in total.

The reason that I bought such deep in-the-money calls is that most of the value was in the intrinsic value of the option rather than the time premium.  Deep in-the-money options don’t carry such a high Implied Volatility as at-the-money options, especially those which expire shortly after an earnings announcement.  That means the calls that I bought were “cheaper” than the October 2013 calls I intended to sell (using my January 2014 800 calls as security).

Since I owned 2 call options at a low strike price I was entitled to use them as collateral to sell someone else the opportunity to buy shares of GOOG at a higher price.  I sold one Oct-13 890 call, collecting $13.50 ($1350) and one Oct-13 935 for $3.50 ($350). 

These option positions gave me the equivalent of 100 shares of GOOG at a cost of $17,200 less the $1700 I collected from selling the two calls, or $15,500.

This was the risk profile graph for my positions that I showed two weeks ago:

Google Risk Profile Graph

Unfortunately, the graph did not extend up to the $1000+ level that the stock moved to, so I will share how I closed out the positions.  When the stock was trading just about $1000 on Friday, I sold one diagonal spread (buying to close the October 2013 890 call and selling to close the January 800 call) and collected $92 ($9200).  That spread had cost me $7250 to buy ($8600 – $1350) so my gain was $1950.  (All these numbers have been rounded to the nearest $50.)

The second diagonal spread (buying to close the October 2013 935 call and selling to close the January 800 call) was sold for $137 ($13,700).  This spread had cost me $8250 ($8600 – $350) so my gain was $5450, giving me a total gain of $7400 on an investment of $15,500, or 47%.

The stock had gone up by 13% and my option portfolio had gained 47%.  How can anyone not love options?

My total commissions on these trades amounted to $10 at the commission rate that thinkorswim offers to Terry’s Tips subscribers.

This is just one example of how I use options to buy the equivalent number of shares of a company I like, and how I can collect a “dividend” each month even if the stock doesn’t actually pay a dividend.  In this case, the stock skyrocketed, and my returns were considerably greater.

Way back when Google (GOOG) went public at $80 a share, I decided that I would like to own 100 shares and hang on to it for the long run. Obviously, that was a good idea as the stock is trading today at $870. My $8000 investment would now be worth $87,000 if I had been able to keep my original shares. Unfortunately, over the years, an options opportunity inevitably came along that looked more attractive to me than my 100 shares of GOOG, and I sold my shares to take advantage of the opportunity.

Many times my investment account had compiled a little spare cash, and I went back into the market and bought more shares of GOOG, always paying a little more to buy it back. At some point it felt like I just had too much money tied up in it. An $8000 commitment is one thing, but $87,000 is real money.

Today I would like to share how I own the equivalent of 100 shares of GOOG for an investment of only $17,000, and the neat thing about my investment is that I get expect to get a “dividend” in the next two weeks of about $1300 if the stock just sits there and doesn’t go anywhere.

I own options, of course. Here is what I own.

Terry

 How to Own 100 Shares of Google for $16,000:  You would have to shell out about $87,000 today to buy 100 shares of GOOG stock. If you bought it on margin, you might have to come up with about half that amount, $43,500, but you have to shell out interest on the margin loan each month. I like money coming in, not going out.

A couple of weeks in this newsletter we talked about the Greek measure delta. This is simple the equivalent number of shares of stock that an option has. I own GOOG 800 calls that expire on the third Friday of January 2014. You could buy one today for $8600. I own 2 of them for a cost of about $17,200.

The delta for these Jan-14 800 calls is 75. That means if the stock goes up by a dollar, the value of each of my options will go up by $75. With these 2 options I own the equivalent of 150 shares of stock.

Since all options decline a little bit every day that the stock stays flat (it is called decay), simply owning options is just about as bad as paying margin interest on a stock loan. As I said earlier, I like money coming in rather than going out.

Since I own 2 call options at a lower strike price that the market price I am entitled to use them as collateral to sell someone else the opportunity to buy shares of GOOG at a higher price. I sold one Oct-13 890 call, collecting $13.50 ($1350) at today’s price. This option will expire in two weeks (October 18). If the stock is at any price less than $890, this call will expire worthless and I will get to keep the entire $1350.

This Oct-13 890 call option that I sold carries a delta of 38, making my net option value 112 deltas (the equivalent of 112 shares of stock).

Since I am aiming to own 100 shares of GOOG, I sold another Oct-13 call, this one at the 935 strike. At today’s prices, this one would go for $3.50 ($350). The delta on this call is 13, reducing my net delta value to exactly 100.

I now own the equivalent of 100 shares of GOOG at a cost of $17,200 less the $1700 I collected from selling the two calls, or $15,500.

The neat thing about my option positions is that if the stock doesn’t go up (as I hope it will), my disappointment will be soothed a bit because I will gain about $1300 over the next two weeks. Here is the risk profile graph for my positions:

Google Risk Profile Graph

The P/L Day column in the lower right-hand corner shows what the gain or loss will be at the price in the first column on the left. (The stock popped up about $3 while I was writing this Monday morning so it is no longer trading at $870 as it was when I started).

There are two disadvantages to owing the options I do rather than the stock. If the stock falls 10%, I will lose about $9800. If I owned 100 shares of stock, I would lose only $8700. On the other hand, if the stock goes up by 10% in the next two weeks, I would only gain $7100 vs. the $8700 I would make if I owned the stock. I don’t think the stock will move by anywhere near these amounts in the next two weeks, so I am content to live with the slightly less I might gain (or the slightly more I would lose) at these extremes.

Today I would like to share an options strategy that we are carrying out in an actual portfolio at Terry’s Tips. It is based on the underlying stock Nike (NKE), and is set up to show how an options portfolio can make far greater gains than you could expect if you bought shares of the stock instead.The options portfolio should make a double-digit gain in the next four weeks even if the stock falls by $3 or so. If you like Nike, you will have to like this options portfolio even more.

Read to the bottom of this letter to learn how you can become a Terry’s Tips Insider for absolutely no cost.

Terry 

How to Use Options to Invest in Nike: Please spend a few minutes studying this risk profile graph carefully. It shows the expected return you would make on an investment of about $4000 in NKE call options in the next 25 days:

If the stock ends up at about where it is right now ($69) when the October call options expire on Friday, October 19, 2013, the graph shows that you could expect to make almost $1000 on your $4000 investment. That is almost 25% and the stock doesn’t have to go up one nickel.

People who buy shares of NKE instead of setting up a simple options portfolio like this one will not make any gains at all while we make over 20% in a single month. Of course, stockholders get to keep the 1.5% dividend that the company pays (regardless of which way the stock price might move). We have to give up that reward in exchange for the possibility of making over 20% in the next month, and presumably, in every subsequent month as well.

Admittedly, this sounds a little too good to be true. But the graph does not lie. Those are the numbers.

The graph shows that if the stock manages to move higher by about $3 over the next 25 days, less money would come our way. Only about 13% (after commissions) on our $4000 investment. But that is still a whole lot better than the stockholders would gain. They would pick up about 4.3% (a $3 gain on a $69 stock), less than half of what we expect.

The biggest advantage to our options portfolio actually comes about in the event that the stock falls moderately over the next month. If it should fall about $3 to the $66 area, the graph shows that we would make a profit of about 11% on our investment. Of course, if that happens, the owners of the stock would all lose money while we are re-investing some nice gains, or taking a little vacation in Provence, or whatever we want to do with those winnings.

It’s particularly pleasing to rack up a nice gain for the month when the stock we picked actually fell in value. We call it the “options kicker” and we really get a kick out of it.

So what does this portfolio consist of, and why can we expect to make money if the stock stays flat or moves moderately either up or down? It all comes about from the decay rate of the options that we own and the options that we have sold to someone else.

This portfolio owns call options with strike prices of 62.5 and 65, and most of these calls are LEAPS expiring in January, 2015. All options fall in value every day (assuming that the stock stays flat), but the rate of decay is much lower for longer-term options like the ones we own. Every day, our call LEAPS fall in value by about $1 each (in the options world, this is called theta). Since we own 7 LEAPS, we lose about $7 a day in decay.

Using these LEAPS as collateral, we have sold October, 2013 calls at the 70 and 72.5 strikes to someone else. These calls decay at the rate of $4 a day, and the 7 we have sold short collectively go down in value by $28 every day. Since our long positions are decaying by $7 a day and the ones we sold to someone else are falling by $28, the portfolio is gaining $21 every day that the stock is flat. This number will grow larger as the October 19th expiration is approached. In the last few days, those options will fall by $15 or so (each) while our LEAPS will continue to fall by only about $1 each.

When the October expiration day comes around, we will buy back the expiring short calls if they are in the money (i.e., the strike price is lower than the stock price) and we will sell November calls in their place. If our short calls are out of the money (i.e., the strike price is higher than the current stock price), they will expire worthless and we will be able to keep 100% of what we sold those calls for. At that point we will sell new calls expiring in November.

This is a simplistic explanation of the strategy. It gets a little more complicated when you have to decide which strike prices to sell calls at each month. Since we are bullish on NKE, we usually sell calls that are mostly at out-of-the-money strike prices so that we will gain both from the increase in the stock price and the decay of the calls that we have sold. The above risk profile graph is typical of what we normally have in place because a bigger gain will come our way if the stock gains $3 compared to what we would make if it fell by $3.

You can use this same strategy on just about any stock. It doesn’t have to be Nike. We also have a portfolio that uses the same strategy with one of my favorite companies, Costco. While the strategy may look a little confusing to someone who is not familiar with stock options, it is actually quite simple. I invite you to become a Terry’s Tips Insider and watch how this strategy (and others) are carried out over time.

Once you learn how to do it, you won’t need us any longer. My goal is for every person who subscribes to my service to learn enough in a few months to be able to quit and do it on their own. But first you need to come on board. It only costs a total of $79.95, or you can get it free if you open an account with our link at thinkorswim.

This week we will start a discussion about the “Greeks” – the measures designed to predict how option prices will change when underlying stock prices change or time elapses. It is important to have a basic understanding of some of these measures before embarking on trading options.

I hope you enjoy this short discussion.

Terry 

A Useful Way to Think About Delta: The first “Greek” that most people learn about when they get involved in options is Delta. This important measure tells us how much the price of the option will change if the underlying stock or ETF changes by $1.00.

If you own a call option that carries a delta of 50, that means that if the stock goes up by $1.00, your option will increase in value by $.50 (if the stock falls by $1.00, your option will fall by a little less than $.50).

The useful way to think about delta is to consider it the probability of that option finishing up (on expiration day) in the money. If you own a call option at a strike price of 60 and the underlying stock is selling at $60, you have an at-the-money option, and the delta will likely be about 50. In other words, the market is saying that your option has a 50-50 chance of expiring in the money (i.e., the stock is above $60 so your option would have some intrinsic value).

If your option were at the 55 strike, it would have a much higher delta value because the likelihood of its finishing up in the money (i.e., higher than $55) would be much higher. The stock could fall by $4.90 or go up by any amount and it would end up being in the money, so the delta value would be quite high, maybe 70 or 75. The market would be saying that there is a 70% or 75% chance of the stock ending up above $55 at expiration.

On the other hand, if your call option were at the 65 strike while the stock was selling at $60, it would carry a much lower delta because there would be a much lower likelihood of the stock going up $5 so that your option would expire in the money.

Of course, the amount of remaining life also has an effect on the delta value of an option. We will talk about that phenomenon next week.

I performed a back-test of weekly SPY volatility for the past year and discovered that in just about half the weeks, the stock fluctuated at some point during the week by $3 either up or down (actual number 27 of 52 weeks).  That means if you could have bought an at-the-money straddle for $2 (both an at-the-money call and put), about half the time you could sell it for a 50% gain if you placed a limit order to sell the straddle for $3.  As long as the stock moves at least $3 either up or down at some point during the week you can be assured that the straddle can be sold for $3.

Here are the numbers for SPY for the past six months:

SPY Straddle Chart

The weekly changes (highlighted in yellow) are the ones where SPY fluctuated more than $3 so that a 50% gain was possible (by the way this week is not over yet, and the stock fell over $3 at one point yesterday).

An interesting strategy for these months would be to buy 10 at-the-money SPY straddles on Friday (or whatever your budget is – each straddle will cost about $200). With today’s low VIX, an at-the-money straddle last Friday cost $1.92 to buy (one week of remaining life),  In the weeks when VIX was higher, this spread cost in the neighborhood of $2.35  (but actual volatility was higher, and almost all of the weeks showed a $3.50 change at some point during the week).

Over the past year, in the half of the weeks when the stock moved by at least $3, your gain on 10 straddles would be $1000 on the original straddle cost $2.  If the change took place early in the week, there would be time premium remaining and the stock would not have to fluctuate by quite $3 for the straddle to be sold for that amount.

The average loss in the other weeks would be about $700, maybe less.  On Friday morning, the worst-case scenario would be that you could sell the 70 straddles for $700 (causing a loss of $1300). This would occur if the stock were trading exactly at the strike price of the straddle – on Friday morning it could be sold for about $.70 because there would be some time premium remaining for both the puts and calls.  The maximum loss that occurred in about a third of the losing weeks was about $.70 but another third of the weeks when the 50% gain was not triggered, you could have broken even (on average) by selling the straddle at the close on Friday.  I calculated that the average loss for all of the last 12 months would be about $700 in those weeks when the 50% gain was not triggered.

This means an average investment of $2000 (10 straddles) would make an average gain of $150 per week. While that might be considered to be a decent gain by most standards, it could be dramatically improved if you varied the amount that you invested each week by following the volatility patterns.

There was a remarkable tendency for high-volatility weeks to occur together.  In the above table you can see that at one point there was a string of 14 weeks when 12 times a 50% gain was possible (high-lighted in yellow) and two weeks (high-lighted in red) when a small gain was possible because the closing price was greater than $2 away from the starting price.  Only one week out of the 14, 5/28/13 would a loss have occurred, and that would have been negligible because the stock closed $1.86 lower, almost covering the $2 initial cost of the straddle.

The same went for low-volatility weeks – there were strings of them as well. At one point early in 2013 the strategy would have incurred a string of seven consecutive weeks when no 50% was possible, and in the last six months pictured above, there were two four-week strings when SPY fluctuated by less than $3 in either direction.

If you invested $4000 in weeks after you made a gain and $2000 in weeks after a 50% gain was not possible, your net gains would be much higher.  This is the most promising part of the strategy.

Another way of playing this strategy would be to invest only in those weeks when a 50% gain would have been possible in the previous week, and sit on the sidelines for the other weeks.  Of course, since the average gain for all weeks was positive (but small), you would be giving up a little by not investing each week.

In this world of low option prices (VIX is at historical lows) and relatively high volatility, this might be an exceptionally profitable strategy to follow.  We plan to carry it out in one of the portfolios we run at Terry’s Tips.

This morning Green Mountain Coffee Roasters (GMCR) fell more than $2, apparently because of a negative article about the company published by Barron’s on Saturday.  I submitted an article to Seeking Alpha in which I argued that Barron’s had inappropriately used some statistics and made some faulty comparisons of GMCR’s p/e ratios and their competitors.

I’m not sure if my article really turned the market around, but in the first two hours after it was published, the stock went from being down $2 to being up $2.50, a swing of over $4.50  or well over 5%.

In this article I recommended buying a diagonal call spread which I will discuss today.

Read to the bottom of this letter to learn how you can become a Terry’s Tips Insider for absolutely no cost.

Terry

Barron’s Article Creates Great Buying Opportunity For Green Mountain Coffee Roasters

In this article I made a case that GMCR would move higher and that the Barron’s article had temporarily unfairly pushed the stock lower.   In a Terry’s Tips portfolio, we purchased the spread I recommended in the article for $10.93.  The natural price is now $12.15 so we have a paper profit of about 10% for the day.

I recommended making a fairly conservative options investment, buying Dec-13 well in-the-money calls at the 67.5 strike when the stock was trading about $78 and selling Aug2-13 weekly calls at the 77.5 strike.  I selected the Dec-13 series because implied volatility of those options (55) was lower than any other weekly or monthly series, and since the December expiration comes well after the next earnings announcement in late October or early November, IV is not likely to plummet after Wednesday’s announcement like the August, September, and October options will probably do.

IV of the Aug2-13 weeklies is a whopping 137, just the kind of options that we like to sell.

This diagonal spread should make an average of about 25% this week if the stock stays flat or goes up by any reasonable amount, and should only lose money if the stock falls by more than 7%.  This seems like a pretty good bet to me, and I have bought a large number of these spreads in my personal account.

The Google (GOOG) spreads I recommended last week resulted in average gains of 58% (after commissions) in Terry’s Tips actual portfolios.  Not a bad day.  The stock fell after the announcement just as we had guessed.

Read to the bottom of this letter to learn how you can become a Terry’s Tips Insider for absolutely no cost.

Terry

How To Play The Seagate Technology Earnings Announcement This Week

I have written a Seeking Alpha article explaining how I would play Seagate Technology (STX) this week:  How To Play The Seagate Technology Earnings Announcement This Week

There are many similarities between the situation in GOOG and Seagate.  I expect the stock to fall after the announcement, and have recommended to buy Aug-13 48 calls and sell Jul4-13 47.5 calls (a diagonal spread) which does best if the stock remains flat or falls.

Please read the entire Seeking Alpha article to get my full thoughts on the diagonal spread play and why I expect the stock will trade lower after the announcement.

A similar situation exists in Starbucks (SBUX) and I have recommended a less risky trade in that company – buying Aug-13 72.5 calls and selling Jul4-13 calls at a credit.  This spread will make money no matter how low SBUX might fall and only starts losing money if the stock moves about $2 higher.

Good luck if you do something this week in Seagate or Starbucks!

This week the earnings season starts in earnest. One of the most interesting companies reporting is Google, mostly because expectations seem to be sky-high and our Expectations Model predicts that there is a good chance the stock will fall after the announcement is made Wednesday after the market closes.

Read to the bottom of this letter to learn how you can become a Terry’s Tips Insider for absolutely no cost.

Terry

How to Play the Google Earnings Announcement This Week

I have written a Seeking Alpha article explaining how I would play Google this week:

How To Play The Google Earnings Announcement …

In the article I suggest buying a diagonal call spread with the long side in August at the 925 strike and the short side in the Jul-13 series at the 920 strike. I placed this spread in my own account today for a debit of $3.60 (in addition to the $500 maintenance requirement per spread, the total cost is about $860 per spread).

This spread should make a gain if the stock goes up by less than $30 (my article explains why I don’t think it will go up at all) or if it falls by less than about $50 (I think this is a possibility but a remote one).

Another possible spread would be to use the same strikes but buy Jul4-13 weeklies instead of the August series. You could do this for a credit of about $.90 which would lower you total investment to about $420 per spread after commissions (the $500 maintenance requirement less the amount of the credit). This spread would make a gain no matter how far the stock might fall (even if it fell to zero) but would start losing money once it rose by about $20 (again, an unlikely event in my opinion).

Another interesting spread would be to pick the strike price (or maybe more than one) where you think the stock might end up on Friday, and buy a Jul4-13 – Jul-13 calendar spread at that strike. It should cost you only about $200 per spread. You can’t lose more than that amount on the trade, and if the stock does end up very near the strike you picked, the spread might be worth $1000 or so. The entire $200 should not really be at risk because your Jul4-13 call should always be worth more than the Jul-13 call, although if the stock ends up at a big distance away from the strike you picked, it might be difficult to get the entire $200 back.

Please read the entire Seeking Alpha article to get my full thoughts on the diagonal spread play and why I expect the stock will trade lower after the announcement.

Good luck if you do something this week in Google!

While we were right on the direction that Accenture (ACN) would take after the earnings announcement (down), we missed how far it would drop (it fell 15% even though it beat earnings estimates). Our diagonal credit spread using calls would have made gains no matter how far it fell but we added a higher-strike calendar “just in case we were wrong about the direction.” That spread lost big-time, and has encouraged us to stick with our model and stop second-guessing ourselves.

Today I wrote a Seeking Alpha article discussing the only two companies with weekly options who announce this week – How to Play the JP Morgan and Wells Fargo Announcements Friday

In today’s report I will have a more thorough discussion of the option strategies I suggested in that article.

Terry

How to Play the JP Morgan and Wells Fargo Announcements Friday

The major point of the Seeking Alpha article was that both companies share similar historic patterns – they consistently beat estimates and the stock either changes very little or falls once earnings are announced. This time around, expectations are quite high for both companies (whisper numbers exceed estimates, and the stock has gone up about 20% since the last earnings announcement and hit new highs this week).

In short, both stocks are in for a likely drop in price after the announcement because some part is likely to disappoint (if not earnings, then maybe revenue, margins, or guidance). We have learned from experience that high expectations consistently result in lower post-announcement prices.

We are buying diagonal call credit spreads in both companies. These spreads will make gains if the stock trades lower by any amount, and will lose if the stock moves higher by a dollar or so (but we doubt that it will move in that direction).

We suggest waiting until late in the day on Thursday to make the trades because the stock often rises in expectation of a good announcement just prior to its being made (and these diagonal spreads should go for a larger credit).

With JP Morgan (JPM) trading at about $54.50, we would buy Jul-13 55 calls and sell Jul2-13 54.5 weekly calls which expire on Friday. Here is the risk profile graph for 10 spreads which could be sold for a $.02 credit right now (but this credit should be higher on Thursday if the stock is higher then):

JPM Risk Profile Graph

If you were to buy 10 spreads, there would be a $500 maintenance requirement (less any credit you were able to get), and that would be your maximum possible loss (which would come about if the stock moved significantly higher). It can go up about $.50 before a loss should result (assuming that IV of the July options falls from 24 to 20 after the announcement). If there is a small downturn in the stock (our belief as to the most likely outcome), the spread could return as much as 50% before commissions. It is a small bet with limited possible gains (or losses).For Wells Fargo (WFC), we are buying Jul-13 43 calls and selling Jul2-13 43.5 weekly calls expiring on Friday. At the present time, this spread could be sold for a credit of $.10, although if the stock price moves higher by Thursday it should be able to be sold for more. Here is the risk profile graph:

WFC Risk Profile Graph

If you buy 10 diagonal spreads, there would be a $500 maintenance requirement (reduced by the $100 you collect from the credit) for a net cost of $400 (which is also your maximum loss which would come about if the stock moves significantly higher).  If the stock stays flat, you would keep the $100 credit plus the remaining value of the Jul-13 43 call.  This is not a huge investment (or return) although it looks like there is a pretty good chance of a 25% gain less commissions for the day (this graph assumes that IV of the July options will fall by 5 after the announcement – it might not fall that much and the gain would be greater if the stock is flat).