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Before I begin, I want to invite you to my upcoming free webinar, “Make 15% a Month – Every Month – for the Next Six Months,” this Thursday, May 15 at 12:00 p.m. ET. I will discuss several income-based options strategies with a few action-specific, real-world trades you can execute right away — including a trade on tech behemoth Apple (Nasdaq: AAPL).
Speaking of behemoths, Walmart (NYSE: WMT) is reporting earnings tomorrow. And I have a good idea of where the stock is headed … and how I intend to take advantage of that information.
How? Look no further than the options market.
Option prices imply what the market expects a stock’s move will be. Options, particularly in highly liquid stocks like Walmart, are priced by the trading of market participants with a myriad of expectations. You use the option price to simply decide whether you think the market is overestimating or underestimating the likelihood of some move in the underlying stock. Then you make your trade (or not) accordingly.
So if you pair the market’s expectation (from the option price) with what you think is likely to come from a specific event in the future, you can begin to decide which strategy fits the expected move of a stock.
Let’s take a look at how we calculate the expected move and what the options market expects out of Walmart after their respective earnings.
Expected Move Calculation = (at-the-money call + at-the-money put + out-of-the-money call + out-of-the-money put)/2.
The top chart shows an options chain for Walmart calls. With Walmart trading at roughly $79 we are going to choose the at-the-money call strike for $0.92 and the at-the-money put strike in the second chart for $0.77. We simply add the two together for a total of $1.69.
The next step is to add the out-the-money calls and puts.
The out-of-the-money calls at the 80 strike are worth $0.49 and the out-of-the-money puts are worth $0.28 for a total of $0.77.
Add both the $1.60 and $0.77 for $2.37 and divide by 2 to equal an expected move of $1.19.
WMT Calls
WMT Puts
Iron Condor Strategy for WMT
So what can we do with this information?
As an option trader I can use this calculation with a strategy I use known as an Iron Condor. This is a range-bound trade and one that I like to use during earnings season with stocks that have high implied volatilities. If you think the market is accurately predicting the expected move of $1.19 selling an Iron Condor would be your strategy of choice.
So let’s delve a little deeper into retail giant.
The implied volatility for May options is close to 25.9%. That is exactly what I want to see – inflated options prices. One way to tell if they are inflated is by looking at options expiring in the following month. In Walmart’s case the implied volatility is only 15%. Perfect.
So if I wanted to sell a far out-of-the-money Iron Condor on Google, I would take the expected move of $1.19 and look to sell strikes outside of the expected range.
With WMT trading at $79.15 the range would be $80.34-$77.96.
So given the expected range above I might simultaneously sell the May 82.5/81 calls and the 77.5/76 puts. Using these options means that as long as Walmart stays between 81 and 77.5 by May expiration (3 days), the risk-defined spread will make roughly 27%. The probability of success on the trade is 79.6%. Those are the type of probabilities that I like to trade.
The next time you hear an analyst proclaim an expected move, ask him if he uses the archaic models of fundamental analysis or the statistically-based models that are quickly taking over Wall Street.
Unfortunately, I think most will respond with the former.
As always, if you have any questions or comments please leave a message a below.
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