Can Home Depot Earnings Give Us a Trading Edge on Lowe's?

The following is a reprint of the market commentary from the September 2016 edition of The Option Advisor, published on August 25. For more information or to subscribe to The Option Advisor -- featuring 10 new option trades each month -- click here.

With the most recent quarterly wave of retail-sector earnings reports now in the rearview, I decided to do some research into a nagging question that has, for a while, been lingering at the back of my mind. For years now, sector peers (and rivals) Home Depot (HD) and Lowe's Companies (LOW) have reported their quarterly results just one day apart. And given the rather obvious similarities in their businesses, I've occasionally wondered whether one could develop an edge in trading LOW on that "tweener" day, based on the market's reaction to HD and on the differences in option activity on the run-up to earnings.

The tradition of HD and LOW reporting earnings on back-to-back days -- HD first, LOW second -- began in May 2013. Since then, the retailers have given us 14 quarterly earnings reports apiece to consider, and the resulting stock moves have shaped up as detailed in the first table below. In the session directly following HD's earnings report, the two equities have moved in the same direction on 10 occasions, or 71% of the time. According to Schaeffer's Senior Quantitative Analyst Rocky White, some 50.8% of the variability of the LOW return on HD's earnings day can be accounted for by knowing HD's return.

Of the four divergent stock reactions to HD's earnings announcement, three of those were clustered back in the second half of 2013 and early 2014 -- and it wasn't until this past February that LOW once again broke stride with HD after the latter's earnings results. On the occasions where the two stocks have moved in sync, HD has consistently logged a greater daily percentage move than LOW (as we might reasonably anticipate, given the nature of the catalyst).

In the immediate aftermath of LOW's earnings report, the two names have likewise moved in the same direction in 10 out of 14 sessions (though not exactly the same 10 occasions as above, notably). However, unlike HD, LOW hasn't always set the pace the day after its own quarterly earnings. Among the 10 times where the stocks moved in the same direction the day after LOW's report, HD actually notched a greater directional move than LOW on three separate occasions (albeit sometimes by only hundredths of a percentage point).

And HD doesn't just act as the "pace car" in terms of price action, but also occasionally on an implied volatility (IV) basis. In five of the last 14 quarters, the average front-month IV on LOW options has peaked the day prior to HD's earnings report, rather than its own. (Of course, any observer assessing HD's outsized influence on its sector peer would be remiss not to observe that HD's market cap stands around $167 billion, more than doubling LOW's market cap of around $68 billion.)

Interestingly, following four of those five HD-centric IV peaks, LOW shares went on to record a significantly greater single-day percentage move the day following their own quarterly results -- meaning options buyers who waited until after HD's report to make a last-minute earnings play on LOW would have garnered the biggest possible bang for their premium-buying buck. Playing this type of occurrence would have been more or less a complete gamble, though, as LOW's average front-month IV has been much more likely to peak the day after HD's report over the last several years.

And yet, while LOW frequently moves in sympathy with HD following the latter company's results, the immediate post-earnings performance of HD doesn't seem to serve as any reliable indicator of how LOW will respond to its own quarterly report. In fact, per Rocky White, the predictive value is less than 1%.

So while the back-to-back reports from America's two premier home goods retailers may seem like a potential opportunity to make a quick-fire trade with an informational edge, HD's earnings reaction is exponentially more likely to serve as a coincident indicator for LOW's price action than a leading indicator. What's more, the tendency for LOW's short-term IV to continue rising in the session after HD's report means that option premiums are likely to be at or near their richest during the trading day leading up to LOW's earnings -- making it a costly time to bet wrong on direction, and a doubly expensive time to play a directionally neutral straddle.

For now, it seems those looking to gain an "edge" on LOW ahead of its earnings would be best served by sticking to our core contrarian Expectational Analysis principles -- namely, performing an objective review of the stock's technical outlook and sentiment backdrop to find possible opportunities for an options play, and avoiding the urge to "force" a trade where one does not necessarily exist.