Baidu is a fun company. The stock has been a great performer over the years, Especially for those that have owned it since the beginning. It is a play on Internet, Advertising & China.
Here we will discuss an idea of how to play the earnings release that is scheduled for after the bell today.
The current expected move for the stock is about $9. That puts the stock at either $65 or $83 by August’s option expiration day. The way to determine the expected move is by adding the price of the two “at the money” options together. With the stock currently trading at $74 a share we can take the $72.50 call plus the $75 put and subtract from there the $2.50 of intrinsic value and that gives us $8.75.
Here is the chart for BIDU
We can read the chart two ways.
The bulls say: This stock is strong, it is currently consolidating for its next leg up. It is holding support and having a tough time breaking to a new high. Don’t worry, that will come with their earnings release. They are killing Google when it comes to China. Only a matter of time before the stock hits a new 52 week high and see $100 a share.
The Bears say:Look at the P/E ratio, enough said! The short interest has been falling but look at the Put / Call ratio, it is rising again. Did you see what happened to Google when they announced earnings. Baidu has always tracked Google and now the past 6 months have been just ridiculous. Everyone thought Baidu would take over market share from Google because China banned Google, but now they renewed Googles license. Wait till the earnings this stock will be a $50 a share.
The options trade:
Instead of going long or short the stock there is an option trade we can do, it is called a vertical spread. I will give the example with Calls but the exact some thing can be done with Puts.
A vertical spread is when you buy say the $75 call for $4.50 and then sell the $80 call for $2.50. This will cost you $2.00 and if the stock stays about $80 a share at expiration you will make $3.
How did that work? The difference between the $75 strike price and $80 strike price is $5. Assume the stock is at $85 on expiration date, your $75 call will be worth $10 and your $80 call will be worth $5, since you bought the $75 call and sold the $80 call you just need to keep calculating the difference in price between the two.
Maybe times in a vertical spread trade you do not need to wait until the options expire to lock in your profit. If Baidu goes up to $100 a share over night, then within a few days you will be able to sell this option combo for $4.95.
Why do a vertical spread?
It is very tempting for many people to buy the $80 call for $2.50 and hope the stock goes to $85 a share and your call will double. The problem with buying calls before earnings releases is that they are very expensive. A vertical spread like this scenario, provides a chance of making 2.5X your money (or almost 3X on the put side) and you don’t need the stock to move too high or low.
There naturally are still risks. With options, if you are wrong on the direction of the move, and you do not take your loss on Thursday morning than your option can become worthless quickly.
If you decide to try and outsmart the market and buy a vertical spread of both Calls and Puts, the stock can decide to shrug off the news, not move and cause your double vertical spread to waste away.
A vertical spread limits the potential profit when comparing it to just buying a Put or Call straight out, but at the same time still gives you potential for a huge return if the stock moves enough to make both options in the money.
Originally published in July of 2010.