Wall Street firms, including J.P. Morgan and Salomon Smith Barney, are gearing up to recommend long single-stock vol positions on companies about to report earnings. While earnings seasons often offer opportunities for going long vol via buying straddles, calls or puts, this season should present plenty of opportunities to benefit from long vol positions given overall negative investor sentiment, said New York-based equity strategists. Worse-than-expected earnings releases from one company can send shockwaves through the entire market.
Surprises on the upside or downside are highly likely for certain companies, explained Jerry Hanweck, head of equity derivatives strategy at J.P. Morgan in New York. The big potential profit from these trades is from gamma, in other words, large moves in the underlying, rather than changes in implied vol. One promising name is pharmaceutical company Schering-Plough, which is announcing earnings on April 19. The company announced in mid-February that manufacturing process and control issues have led to reduced sales of certain products in the U.S., which it expected to influence its first quarter and full-year sales and earnings. On Friday, as DW was going to press, options maturing in August had a mid-market implied vol of around 43%, which implies a 2.75% move in the stock per trading day. Over the last month, the stock has been moving on average 3% a day, which means that by buying options on the company, you're getting vol cheap.
Wachovia is also attractive, noted Hanweck. The regional bank's asset quality is deteriorating, as the economy slows. Equally important is the fact that the U.S. Federal Reserve has been cutting interest rates. If it cuts interest rates more than expected, bank stocks rally, whereas if it cuts them less than expected, bank stocks sag. Either of these would point to high volatility in the near term. Wachovia reports earnings in the middle of this month. Options maturing in July were trading at mid-market implied vols of around 36% last Friday.
Salomon Smith Barney is now looking at which names to recommend for options plays. SSB typically recommends clients buy options about 10 days before earnings announcements. Market makers typically start bidding up vol then in anticipation of directional hedge funds taking views on stocks ahead of earnings announcements, said Ryan Gould, equity derivatives strategist in New York. Buying the options any earlier means the investor takes too big a hit on time decay, but over the 10 days preceding earnings announcements, vol for many companies rises steadily. One company for which this trade has historically been profitable is Intel. Vol for options expiring April 18 is 66%, but that number could rise as high as 80% in the 10 days preceding its earnings announcement later this month.