Serious Yahoo

So I was all set to go through the Yahoo! options board and derive an earnings-move guestimate for tonight. But fortunately, Steve Smith on RM beats me to it.

I'm going to take a look at former Internet giant Yahoo (YHOO), which reports earnings on Wednesday. And despite its diminished stature, investors are actually expecting quite a large price move -- in the $2.10, or 8%, area -- following the earnings report.

How do I arrive at that number? One way is to simply take a look at the current option prices of the near-the-money strangle, in this case, with Yahoo stock trading at $26.50, the $25 put is trading around 55 cents and the $27.50 call is trading around 60 cents. This is a value of around $1.15 for the strangle, giving the options an implied volatility in the 75% range.

The next step is to assume that immediately following the earnings report, regardless of the ensuing price move, that the IV of the options will decline back to its 20-day average around the 40% level. If Yahoo's shares remain between $26 and $27, the decline in IV will cause the value of the strangle to decline about 27%, to around 30 cents.

It's a little tricky on expiration week, as the options become so dollar-cheap it's difficult to predict a volatility.

That being said, It's pretty clear there's not going to be much bid for July's wherever the stock goes. Steve's thought?

For the owner of the strangle to make money, the shares would need to be beyond the breakeven points, which using 40% implied volatility, are $24.40 on the downside, or $28.20 on the upside. But given that the 20-day historical volatility of Yahoo has been a mere 17% -- and that the acceleration of time decay will go into overdrive in the last two days prior to expiration -- assuming a 40% IV after the earnings might be quite generous.

This leads me to think that selling the strangle might be the better play. If one wants to cap or limit the risk, an iron condor can be created by purchasing the July 22.50 puts for a nickel and the July 30 call for 10 cents. This reduces the total net credit to $1, but will deliver the maximum profit if shares of Yahoo remain between $25 and $27.50, a 9% range, for the next four days. The breakeven points are $24 and $28.50, a 13% range. The maximum loss is capped at $1.50 if shares fall below $22.50 or rise above $30 on Friday's expiration.

A look at the chart does say the 40% volatility may be generous. I could easily see a move to the mid 30's. Which maybe makes the Augs a good play as well (they carry about a 44 volatility now).

I generally don't bother to buy the outer wings when I do a play like this. But then again they're usually not that cheap, so it isn't the worst idea in this example. Selling Augs should yield similar results to selling July's (provided the stock stays with like 4-5 points of here) so maybe selling the Aug strangle and buying the July wings make more sense than anything? Just thinking out loud here.

I am not going to play this one, mainly because I prefer higher priced stocks (and options).