By the time this gets published, the Consumer Price Index report will have been released and we’ll know how the market is going to react to inflationary readings, but I don’t think the market is likely to have that much of a reaction unless the numbers are outside of an expected range.  The reason is that the Fed has already hinted at going back to raising interest rates at their next meeting.  We’ll likely see another 0.25 basis point increase, therefore the CPI report doesn’t matter as much other than it will make an unknown known. 

To put things in perspective, here is what the market was expecting for the CPI report.

Tomorrow we will have the Producer Price Index – Final Demand and here’s what the market is expecting to see from that report.

If the consensus is accurate, the various inflationary measures are heading in the right direction.  The market is likely to respond positively as the SPX continues its march higher to the 4500 area.

I’m looking for the S&P 500 to reach 4500, drop lower, and then head back up to retest the level.

Earnings season starts soon and it’s usually the banks that go first. I don’t think the banks will have it any easier as interest rates climb and people pull money out of the banks, but if JP Morgan (JPM), Citi (C), and Wells Fargo (WFC) come out strong and indicate that the financials aren’t as bad as it seemed last March, we could certainly see the broader market keep moving higher for now.

Speaking of the broader market, look for the equal-weighted ETFs of the major indices to outperform. That’s the QQQE for the Nasdaq 100, the RSP for the S&P 500, and IWM for the Russell 2000.

Today’s trade idea is going to be an earnings trade. Block ock (BLK) releases earnings on Friday before the opening bell.

If you look at the options chain for the 14 JUL series, you can see that the implied volatility is 44.56% and the expected move is plus or minus 22.59.

That is telling you that the market makers are expecting that BLK won’t move more than $22.59 in either direction by the close of Friday after earnings are released.

A calendar spread is a long-vega trade, meaning that a calendar spread increases in value as volatility increases. And what is something that causes an increase in volatility?

Earnings!

Let’s look at selling the 14 JUL 710 put while simultaneously buying the 21 JUL 710 put. This is currently trading for a debit of around 2.40.

Here’s the profit loss graph and I’ve forwarded the graph to 7/14, the date of earnings. The red curved line shows our potential profit on that date. The vertical white lines indicate the expected move (+/- 22.59) and the horizontal red lines indicate the potential break-even points of this position.

As long as BLK trades within its expected move, this trade will be profitable by the close of Friday. It can even extend slightly out of its expected move range and still be profitable as indicated by the vertical red lines.

Now, since calendars work well in rising volatility environments, you can also look to close out of this trade before earnings are released because volatility will drop as soon as earnings are released. You can see that by looking at the implied volatility of the following week’s option chain. Implied volatility is expected to drop from 44% to 32%.

So one way that I will trade earnings plays is to look at the peak max profit of the position I mentioned earlier. The trade will cost us 2.40 per spread, or $240. The max profit at expiration (the peak of the graph) is about $880, but that would require BLK to close exactly at $710 at expiration.

Instead, what if we set a profit target of 20% of the peak? That would be 0.20 * $880 = $176. If we can make $176 off our $240 investment, that means we could make a 73% return in a few days.

We’ve certainly seen stocks jump around earnings, and that could certainly happen here. There is a risk of a gap up or down. A 5% move in either direction could end up costing you a $100 loss. That’s another reason why I like to try to exit these trades before the earnings announcement and take advantage of the increase in volatility leading up to the actual announcement.

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Jeff Wood

Editor, Filthy Rich Dirt Poor
Coach, Options Testing Lab