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How NOT to Gamble on AAPL Earnings


An options trader said on CNBC to buy OTM call spread before AAPL earnings. The headline was Here's how I plan to quickly make 317% on Apple. Nice headline and nice way to attract viewers. But was it a good way to trade earnings or was it a pure gamble? We are about to find out.

"Todd Gordon of TradingAnalysis.com starts by pointing out that the tech giant is expected to rise or fall just $3.50 on earnings. Yet Apple moved more than the options market expected in the past two earnings events."

 

While this might be true for the past two earnings events, when you look at longer timeframe, AAPL tends to move less than expected. Take a look at the screenshot from optionslam.com, showing the post earnings movement of the stock in the last 10 cycles:

 

aapl.PNG

 

The last column shows the one day post earnings performance of the weekly straddle. As we can see, it has lost money 7 out of 10 times. Which means that 7 out of 10 times the stock moved less than expected. If I had to choose, I would take the other side of the trade (selling those options).

 

"Based on the charts, Gordon sees the stock going higher. Apple has been badly lagging its large-cap tech brethren of late, and he sees that trend tuning around."

 

Let me tell you a secret: when it comes to earnings, charts mean NOTHING. Earnings are unpredictable. reaction to earnings is even more unpredictable. 

 

So what was the recommended trade?

 

"He recommends buying the 101-strike weekly calls expiring on Friday, and selling the 102-strike calls. This trade will cost a total of 24 cents per share, and return a profit of 76 cents, or 317 percent, if Apple closes the week at $102 or above. "It's a little bit of a gamble," Gordon granted, "but we have an attractive reward-to-risk ratio."

 

My comments:

  1. It is true that the risk/reward is attractive. But risk/reward should be viewed in context with probability of success, as we discussed here and here. For example, if you buy 104/105 call spread, your risk/reward would be even better, but what is your chance to realize this reward?
  2. Based on the 102 calls deltas, the probability of AAPL closing above $102 this week was around 10%. Which means that this trade had only 10% probability of success.
  3. In order for the trade to succeed, you had to be right three times: direction of the move, size of the move and timing of the move.
  4. We know that earnings are always 50/50 (and we can see that in the last 10 cycles, AAPL moved 5 times up and 5 times down). 
  5. You needed around 6% move which is almost double the predicted move.

 

Considering all the factors, I consider this trade a pure gambling. In fact, Todd Gordon admitted that the trade is a little bit of a gamble - major understatement to me.

 

What would be an alternative to go bullish on AAPL before earnings? Well, if you were bullish but still wanted some margin of safety, you could sell weekly 92/93 put spread for $0.20. Your potential gain would be "only" 25%, but your probability of success would be over 80%. The trade makes money if the stock goes up, remains unchanged or goes down around 4%. You could be wrong and still make money. Again, lousy risk/reward but high probability of success.

 

AAPL is up 6% after hours as I write this. This trade might end up a winner (the price should hold above $102 till Friday). But does it mean it was a good trade? Not to me. Remember: not all winners are good trades, and not all losers are bad trades. Trading is all about probabilities. In this case, probabilities were not in our favor. Not even close.

 

We all know (at least I hope that you know) that CNBC's first priority is NOT to help you to make money. It is to maximize ratings and to attract advertisers. But sometimes their methods are highly misleading and unethical. Remember that when watching any of their programs.

 

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Yes he was. But final result does not necessarily mean the trade was good. AAPL stock had its nest day in 2 years - http://money.cnn.com/2016/07/27/investing/apple-stock-soars-earnings/. Could you really predict this before earnings?

Here is the most disturbing part: someone replied to Todd Gordon on Twitter:

Capture.PNG

Next time he recommends something like this, some novice traders might really do more contracts, not understanding the probabilities, and lose their shirts.

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