Thursday, May 6, 2010

Rosetta Stone (RST) - Smart Earnings Skew Trade To Make Delta Bet

RST is trading 25.25 with IV30™ up 2.3% on earnings coming out today AMC. The LIVEVOL™ Pro Summary is below.

The company has traded over 5,600 options in the first half hour on total daily average option volume of just 745. All but 38 contracts have been calls. The largest trade has been a Jun 25 / May 30 call spread (buy Jun sell May) and paying ~$2.00. The Stats Tab and Day's biggest trades snapshots are included (click either image to enlarge).

The Options Tab (click to enlarge) illustrates a few things:

1) The trade is selling 95 vol in the May 30 calls.
2) The trade is buying 71 vol in the Jun 25 calls.
3) The ATM front month straddle has fair value of ~$3.80 (this is a $25 stock).

The Skew Tab helps demonstrate this difference in vols graphically (click to enlarge).

I've highlighted the May 30 and Jun 25 calls. You can see the dramatic difference in vol. This makes sense since earnings are coming up today and the May options are quickly nearing expiration.

At this point I like the trade - buy low vol sell high vol. But, it is still long vega into earnings - and this is some seriously high vol. Why is it so high?...

The Earnings & Dividends Tab is included (click to enlarge).

What we're lookin' at:
(1) The top ROW is RST stock price 5 trading days before earnings through 5 trading days after.

(2) The second ROW are the front 2 month ATM straddles for the same period - focus on purple.

(3) The third ROW is the implied vol for those straddles - focus on the red - the front month. NOTE: The red line always collapses after earnings - this is called the vol crush after earnings.

For the one day close prior to earnings to the day after close:
5-11-2009: The stock moved from $29.47 to $26.80
7-30-2009: The stock moved from $27.31 to $30.69
11-5-2009: The stock moved from $20.51 to $18.38
2-25-2010: The stock moved from $17.34 to $22.00

So the stock can move a lot after the earnings announcement. It's moved up twice and down twice in the last four cycles (they've only had four earnings cycles). This much movement/reaction to earnings is going to yield high vol (as we see now).

This trade buys cheap vol, sells expensive vol and bets on an upward move after earnings. If the stock pops to the $27 or above level, this is going to be a great trade. I like this approach for someone getting long. Of course, I have no idea if getting long is the right move.

Finally, the Charts Tab (2 years) is below (click to enlarge). The top portion is the stock price, the bottom is the vol (IV30™ - red vs HV20™ - blue).

You can see the stock gaps on earnings on top. On the bottom, when the blue line crosses the red line - that vol was a purchase.

This is trade analysis, not a recommendation.

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