Henry Schwartz for CBOE Options Hub
A quarter of the 3537 stocks with listed options release their fourth quarter earnings reports this month. Alcoa (AA) is typically considered the stock to kick off the earnings season- but that most traders will tell you earnings never really stop- in fact Best Buy (BBBY) was a day before Alcoa this year. Regardless, 886 stocks report this month, including option-market volume leaders JPM, BAC, and C this week and technology names NFLX, MSFT, AAPL and YAHOO later in the month. Earnings are an important catalyst for traders looking to speculate on how the market will react to the data, with a predictable uptick in option volume. For example, AAPL volume for the week ahead of earnings last quarter averaged 587K/day, well above the prior week average of 373K. Weekly options expiration cycles have boosted earnings-trades as well, since option durations can be selected within a few days of earnings in many cases.
For liquidity providers and dealers, earnings can be a tricky time to trade since the whole concept of model-based pricing goes out the window with that instantaneous ‘gap’ reaction in share price and temporary departure from the assumption of Brownian motion that is the foundation for most models. Related P&L swings can be violent and binary nature of the event makes trading through earnings a bit of a specialty among trading desks that strive to provide the best experience for their clients while controlling risk as much as possible.
While trading through earnings is clearly a (stressful) art, there is a mathematical approach that is common among traders who want to estimate magnitude and direction of a stock’s reaction to their release. A starting point is simple analysis of the historical behavior of shares- or ‘what did this stock do previously? ‘ Since many stocks tend to have consistent behavior over time, it’s reasonable to expect that a stock that tends to move 10% following each release is likely to move 10% this time. More history and additional statistics can help the process, so using Intel (INTC) for example, which reports Thursday afternoon, we can see last quarter’s 1.3% gain, and going back further over two years we see the moves average 2.7%, with a median of 2.7%. We can also see 7 of the past 8 moves were declines.
Options market prices give us another way to estimate of the magnitude of the expected move- effectively the level of implied volatility in the ‘earnings-expiry’ options implies a specific amount of additional movement – and for this purpose we can assume the difference is related specifically to the earnings event. To isolate the ‘earnings’ volatility we weight the difference in volatility between near-term and longer term to that single day of earnings to obtain the implied volatility of that single event.
The model we use is outlined here, and quants may differ a bit on their approach, but the net result is similar and gives a good guideline level for the expected behavior immediately post earnings. A live snapshot of Intel shows how the near-term near-term options, with at-the-money implied volatility near 37%, with the next-term implied volatility near 27.5%, works out to indicate a 4.5% standard deviation, or about a $1.25 move based on current spot. It’s important to keep in mind that this standard deviation is a probability interval, not an expected move (recall from stats that in a normal distribution, 66% of the time we expect to see a move within a single standard deviation).
Weekly options that fall very close to announcements give traders a quick-and-dirty way to estimate the expected move. Our current earnings gap snapshot shows that Intel is trading near $25.89 and the $26 straddle expiring Friday is priced near 90cents, or 3.5% of spot. This is the market estimate of the ‘expected gap,’ which can be viewed as a ‘likely move’ by the market. This makes intuitive sense since a buyer of that straddle right now will need INTC to move 3.5% to break even.
When a stock implies a move significantly different from recent moves there is usually a reason. Changes to capitalization, business lines, and recent moves in correlated stocks are important factors to consider.
Divining direction into an earnings release is much more ‘art’ than science. Option flow analysis can show what strikes is those short term ‘earnings’ options are most in demand and where the open interest is building. In the case of Intel, Jan 25 puts have seen most of the volume over the past few days, while open interest has grown to over 106,000 contracts, but we have several more days of flow to watch before we have a complete picture of that ‘last minute’ positioning into the news. Sell-side traders who see a lot of order-flow and know their customers try to develop an awareness of who’s getting long or short into a release in order to go-along with the smartest and happily take the other side of the ‘dumb money’ trades.
A list of this month’s earnings names with average daily option volume and implied volatility is posted here. Among the ‘Top100’ by volume, several appear set to exceed their historical move by a significant amount. Of course prices are always moving so this is just a glimpse, but it’s certain that we will see a surge of short-term volume in most of these as the cycle plays out.