Kevin Cook Baidu (图)

Baidu Inc. (NASDAQ:BIDU) is set to report earnings after the closing bell today, with consensus estimates of 31 cents per share (EPS) according to Thomson Reuters, and a whisper number that could more than double its year-ago EPS of $1.61. WhisperNumber.com is showing this morning that BIDU may come in two cents better at 33 cents EPS. Wait—how can 33 cents EPS be double last year’s $1.61 EPS? Because of the 10-for-1 stock split, which, on an apples-to-apples basis, equals $3.30. What kind of price movement should we expect if BIDU beats or disappoints the street? One place to get some clues is from the options markets and the tea leaves of implied volatility. Implied volatility (IV) is simply a measure of expected price movement, and thus risk, as reflected in the premiums being paid for options. Below is a snapshot of the Implied Volatility Chart tool at OptionsHouse displaying put and call IV for the past six months. Several points are worth noting on this chart, starting with the beginning of the year when BIDU option volatility shot up above 50%. That was a time when the “Google-China wars” were heating up and BIDU stock was the prime beneficiary. BIDU shares launched to $500 from below $450 very quickly as institutional investors and hedge funds started paying more attention to the company’s potential if it were to become the sole king of the web in China. Next, notice how the volatility quickly became subdued again for nearly three months from early February through April. If you look at a price chart of the stock, you will see the slow steady climb that BIDU made from $500 to $650 during this time. This makes complete sense, because when a stock has small daily ranges, its volatility goes down, so that even a $150 move higher doesn’t drive option prices higher on a stock-relative basis. There is also the phenomenon that pro option traders are familiar with where volatility generally declines as an asset price rises, all else being equal, because a $1-move doesn’t carry the same effect relative to the stock price, but it’s still $1 of risk or profit that people care about and trade all day long. This leads to our next part of the discussion in addressing the dramatic new volatility environment that BIDU entered in May and that has sustained into July. At first glance, investors might think that volatility rose because of the stock market correction and “flash crash” that will always mark the month of May 2010. But BIDU’s rise has more to do with the 10-for-1 stock split that occurred in early May and it’s new “wild” trading range between $65 and $80 for the past few months. Put volatilities haven’t soared because the stock dropped below its 50-day moving average—BIDU has been comfortably hugging that key trend marker since May as its momentum actually slows down. And this stock is still $20 above its 200-day moving average, which it hasn’t even touched in over two years. Option implied volatility is simply in its new normal home for this $75 stock, somewhere between 50 and 70%, just like its 30-day historical volatility (actual as opposed to implied). What’s the probability of a $12 move? One great way to take implied volatility information and get a gauge of possible stock price moves is by using a Probability Calculator. The screen shot below is from OptionsHouse, but the actual tool is interactive and allows you to enter a variety of time, price and volatility inputs to see how they interact. In essence, this tool lets you put some statistical foundation underneath your trading ideas. We probably won’t get a $12 move in BIDU this week after their earnings report—unless, of course, they miss or beat the whisper number by a significant margin. This 55% implied volatility for August options is telling us that BIDU could move as much as $12 higher or lower between now and expiration in 30 days. The Probability Calculator converts the annual standard deviation of 55% (volatility is, after all, simply standard deviation of historical or expected price changes) into a volatility of about 16% for the next month. While statistical probability for BIDU tells us that the stock could be within a range of 55% higher or lower one year from now, it suggests that it will be contained within a $24 ($12 up or down) range with approximately 68% certainty. Why option implied volatility is so good at making predictions—most of the time Earlier this week, we looked at Apple Inc. (NASDAQ:AAPL) and Goldman Sachs Corp. (NYSE:GS) volatility and expected price moves ahead of their earnings reports. If you read those reports (links below) you will see the options markets gave a very good idea of expected price movement. This is generally the case for very liquid stocks like these because there are so many participants involved in trading their options. It’s like the line on an important game in Las Vegas—the more bettors wagering, especially the so-called “smart money,” the more “in-line” the line becomes and the less edge there is to take advantage of mis-priced risk. When you can make bets or trades with the statistical edge of 68% on your side, you may not win “most of the time,” but you will win in the long run. And in investing or trading, the long run is what counts the most. To use the Volatility Charts, the Probability Calculator, and other professional-level options trading tools, be sure to check out the free virtual trading account at OptionsHouse. You can even use a dynamic Profit&Loss Calculator that allows you to build complex strategies and watch how changes in time and volatility and price affect them. Then you can enter the trades in a practice account and watch how they would work out in real time, without the real risk. These tools are hands-down the best ways to learn about options volatility and probability because what a book of someone else’s examples could never teach you is what you would do with actual strategies that you design, execute, and test yourself. Apple (AAPL), Goldman Sachs (GS) Earnings Volatility Preview Apple (AAPL) whisper number could be positive surprise Google (NASDAQ:GOOG) Earnings Trade: What’s the probability of a $30 move?