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July 29, 2012 / redman59

Earnings Trade Idea for MasterCard

Going into next week we have MasterCard (MA) reported Aug 1st before the market so traders have 2 market days to prepare for any move.  I chose to do an analysis on MA due to its higher price and availability of weekly options.  Going into earnings we can see that over that past 6 earnings cycles MA has a history of beating expectations on a EPS and revenue basis with the exception being the last 2 quarters with MA missing on revenue expectations.

Going into earnings I only trade options as you can structure your risk more favorably than trading stock and you can even structure it accepting a 100% loss on the play in accordance with your portfolio risk.  Below is a table that I structured for MA of its 6 previous earnings cycles:

This data takes into account statistics into the close the day before it releases earnings and the next day after it releases earnings 1 minute into the open.  I use this data to interpret the expectations going into earnings, the volatility, and the results if volatility was a better buy or sell.

Going into earnings I look at what the straddle bid is currently 19.05 and I look at the StDev Move and the Augen StDev move average.  In this case I decided to leave out the one outlier of 2/3/2011 as we saw a small move and the other data will structure my risk more favorably.

So in this case I am going to take the current StDev move (6.82) and the average Augen StDev move 1min after (2.41) and multiply them and I come up with the number 16.44.  So this tells me that the current standard deviation move priced multiplied by the average move that has happened is 16.44 points.  Right now the straddle is pricing in a 19.05 move, so I am thinking to sell volatility.  But also I want to go and look at the earnings historical move and whether volatility was a buy or sell and right now it looks like a coin flip as the straddle mid price 1min after the open favored a sell 4 out of 6 times with 2 of them being close whether you could get filled near the mid or not.  Also I consider only one of the earnings to be a blowout (11/02/2011) which was to the upside.

Going to the chart I can see that we have some decent support and resistance areas near 390 and 445.  I also like to look at the 3rd Standard Deviation Bollinger Bands for magnitude of a move, both currently showing approx. 5-6% away from price.

So taking into account all the information I am looking to sell volatility into earnings.  While I believe the straight straddle sell is expensive and maybe not available to all customers I am looking to sell the Iron Condor.  This is effectively the same idea with a capped loss.  Unfortunately the reward is not as much either but I like the fact that my risk is capped.

My trade idea is selling the 395/400/460/465 Iron Condor at 1.09.  The credit received will be $109 and the max risk $391.

Now that I have an idea I want to forward test the expectations of selling volatility based on the average implied volatility (IV) drop we have seen in the past.  Looking back at the table we can see that the average ATM call IV change has been 37.46%.  The only problem that I can see now is that historically the ATM call IV has been a lot higher with it really starting to kick in when MA started doing weekly options for earnings (11/02/2011).  So with current ATM call IV being around 43.50% I want to go back and look at a recent move where the ATM call IV was around the same.  This brings me to the IV drop back on 8/3/2011 and it dropped around 22%.  Now I will use this looking forward:

Plugging in the data it shows me that my breakevens at the end of the earnings day would be 406.64 to the downside and 456.64 to the upside and if my expiration breakevens were hit would create around a 100% loss on the credit not the total position.

Looking at this forward data and based on prior volatility and price moves I really like the Iron Condor here, especially over a straddle sale as I am more comfortable with the risk in case a blow out happens like we saw 11/02/2011.

In summary, remember these are approximations on forward looking data and all  I am doing is trying to guess based on recent data and how the chart structure looks into creating  the trade plan.  With earnings it is important to remember that anything can happen and no matter the historical moves or homework you do on the current trade, it can all go to hell with one number or some words during the conference call.  Structuring the trade round your risk tolerance is the most important factor.  Also note I have not taken into account any prior news, forward looking news, product information, or just overall company performance as I believe there are too many factors and a lot more people qualified for that.  I get lost in the fundamental reasons and just pay attention the numbers.

**Also with MA the option spread is fairly wide so if trading spreads be patient or come off the mid-price a little more than you usually would.

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