Schaeffer's Outside the Box Blog

Earnings Drill

by 12/19/2012 7:38 AM
Stocks quoted in this article:

It's earnings pre-season. While most names don't announce their results until mid-January, we have a few scattered high-profile companies reporting this week. And even if you don't trade (or particularly follow) these names, it's still instructive to note how they perform versus expectations.

But first, a quick refresher on what we're looking for here.

Options volatility ticks up ahead of earnings news. The closer a particular option expires to the release of the news, the greater the bid-up in volatility terms. If you plotted the volatility curve on a graph pre-earnings, you'd see a steep slope between near-term expirations and very flat slope in the outer cycles.

We can calculate the implied gap move in the stock based on the slope of the volatility curve. And by "we," I mean that in 2012, we can use our trading system to calculate it for us. If you use ThinkOrSwim (TOS), for example, this number shows up as "MMM" (for Market Maker Move) on the "Trade" screen. It's expressed as an absolute number, but we can obviously convert it to a percentage move.

So let's say stock XYZ trades at $50, and we see an implied move of $2.50, or 5%. This suggests the market expects to see XYZ gap about $2.50 after the earnings release, with no direction specified. Theoretically, a trader with a delta-neutral position on will break even. The change in absolute price in the stock will offset the drop in implied volatility. Of course, no position works perfectly like this, nor does any prediction like MMM perfectly capture what will happen to the volatility curve after the news. It's an approximation, so it has more informational value than anything else.

And that breakeven level is interpreted exactly like a standard deviation. In the example above, we would expect XYZ to gap under "the number" 68% of the time. The risks of a move above the "number" are open-ended, so thus a trading strategy of selling every name ahead of earnings will win more often than it loses. BUT -- the magnitude of the losses will be greater than the wins. In a perfect-pricing world, the expected value of the strategy over time is zero.

But of course, pricing is never perfect, and that's why it's instructive to take a bigger-picture view of earnings season. Perhaps the bid-ups are too great and there's opportunity in selling options ahead of earnings, at least until the market inevitably adjusts. Or vice versa. We're going to start tracking this a bit, and see where it goes.

We don't have too much to track just yet.

NIKE, Inc. (NYSE:NKE) reports after the close tomorrow. As per TOS, the options marts expect about a 4.5% move on earnings. Last cycle, Nike opened down about 2.5%, though it did ultimately make up the gap. So it was a win for options shorts, though perhaps a little dicier than meets the eye. In June, though, it was a big win for the options longs. NKE gapped down 10% and it took a month to refill the bear gap.

We'll also hear from Research in Motion Limited (USA) (NASDAQ:RIMM), maker of some sort of smartphone that was hugely popular during the Ford administration. Mr. Options Market expects about a 10% move, though keep in mind that's only $1.35 these days. Nothing much last go-around, but RIMM did see a huge gap down (in percentage terms) in June.

Anyway, we'll follow up on how these pups act relative to the "number," though given there's a pause in reports the next couple of weeks, I'm not sure how much info we'll get about the coming cycle.

Disclaimer: The views represented on this blog are those of the individual authors only, and do not necessarily represent the views of Schaeffer's Investment Research.

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