Friday, April 25, 2014

Twitter (TWTR) - Pre-earnings Note: The Art and Science of Odds Making with Options. Did You Know This? The Pros Do.

There are updates to this article embedded below.

TWTR closed Friday trading at $41.61, down 7.2% with IV30™ up 5.3%. The Symbol Summary is included below.

Provided by Livevol

UPDATE: 4-28-2014

Provided by Livevol

Note the IV30™ rise -- that's a direct measure of risk and it's now reaching quite elevated levels.

This is a pre-earnings note.  The last article I posted on TWTR surrounding volatility was a boom-boom.  You can read that one (post-mortem) here:

TWTR - UPDATE: How the Option Market Totally Blew It, And We Knew it Two-Weeks Ago.

In that article, believe it or not, we saw TWTR vol priced at 57%. Two weeks later the volatility spiked to 111% and the stock had moved $22 (~30%).

This time I see a very cool volatility set up into earnings, but quite different than that last note. This is gonna get good.

Let's start with the Charts Tab (two-years) below. The top portion is the stock price, the bottom is the vol (IV30™ - red vs HV20™ - blue vs HV180™ - pink).

Provided by Livevol

I note two phenomena:

1. The stock is down big recently and since IPO (first trade IPO).
2. Check out that gap in the first (and only) earnings announcement they have had as a public company.

So, keep that in mind -- last earnings was a huge mover and back in Dec, the market totally understated risk -- almost absurdly so,

Now let's turn to the IV30™ chart in isolation, below.

Provided by Livevol

UPDATE: 4-28-2014

Provided by Livevol

Check out how that volatility is rising. The option market is reflecting greater risk. The general malaise that has surrounded earnings in the momentum stock is finally changing.

So all of that history actually has made its way into the option market.  The current IV30™ is above the last earnings level and is very close to an all-time high.  Keep in mind that earnings are due out 4-29-2014 AMC, so there is likely a rise in volatility still to come.

Unlike my feverish earnings previews over the last two weeks calling volatility too low (see some links below), this time I see a different kind of opportunity.

AAPL - Earnings Review: How the Option Market Blew It... And We Knew a Week Ahead of Time..

AMZN - Earnings Review: Stock Gaps Off of Earnings; and We Knew it Yesterday.

Let's turn to the Skew Tab snap (below).

Provided by Livevol

While the skew is rickety, it has maintained what would be considered a normal shape.  Oddly, coming into earnings for an IPO MOMO technology stock, I kind of expected parabolic skew.  More on that in a sec...

To read more about skew, what is and why it exists you can click the title below:
Understanding Option Skew -- What it is and Why it Exists.

Finally, the Options Tab is included below.

Provided by Livevol

Here's where it gets really interesting and also why I posted this article after hours (so no one would trade on this blog).

The option market prices TWTR stock range as [$35.25, $47.25] by the end of trading on May 2nd.

  • If you believe the stock will be outside that range on expiry or any date before then, then you think the volatility is too low.
  • If you believe that range is too wide, and that the stock will definitively be in that range on expiration, then you think volatility is too high.
  • If you're not sure, and can make an argument for either case, then you think volatility is priced just about right.

But, checkout those option prices more closely and watch this EXAMPLE trade set-up:

Sell 1 $41.5 strike straddle @ 6.05 (fair value = $6.10)
Buy 1 $38.5 strike put for $1.70
Buy 1 $44.5 strike call for $1.85

Net credit (Max Gain) = $6.05 - $1.70 - $1.85 = $2.50
Max Loss = $3.00 - $2.50 = $0.50

This is how the option market reflects odds. In this case, the option market reflects 1:5 (0.50/2.50) odds that TWTR stays in the range [$41.50 - 2.50, $41.50 + 2.50] ---> [$38, $44] by May 2nd.

That was strictly science (arithmetic).  The art is in finding the combination of strikes that one finds to be priced for positioning.

Art: Try that out a few more times using different strikes, and you may be surprised what you find.  But don't trade on my analysis!!!!!!  I do not have a license to give advice, this isn't advice, it should never be construed as such.  No comment here or ever should be construed as a solicitation of any security or trade or anything ever.

This is trade analysis, NOT a recommendation.

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