Lessons in Probability: A Post-Mortem on Apple Inc. (AAPL)

In the middle of our semi-daily panics about Europe, someone decided to throw in an earnings season. When I think of it, I try to tweet out higher-profile earnings estimates. That is, estimates of the magnitude of the earnings move as suggested by the options volatility curve as calculated by ThinkorSwim.

On Tuesday, for example, I noted that Apple Inc. (NASDAQ:AAPL) options priced in a 6.3% move. All options across the board get bid up in volatility terms ahead of earnings in a stock like AAPL. But the bid-up is larger in options that are closer to expiration. So that estimate is based on the degree of the bid-up relative to the bid-up in further-out options. It's important to note that it's an estimate. The whole volatility board may react more or less to the number.

So what does that number tell us? In theory, it gives us the point where both volatility-long and volatility-short strategies break even. Obviously not everyone in the pool has the same experience, because real-life positions are always more nuanced. But it's a good approximation to an equilibrium move. It's almost like a pin at expiration. If the stock is near that level, there's neither extreme pressure from trapped options shorts nor options owners seeking to offset the volatility drop that's about to happen. Get away from that level and you could see a move compound upon itself.

And it's important to remember that the estimated move is akin to a standard deviation. As a whole, roughly two-thirds of names will move within their earnings estimates, and one-third will make larger moves. It's a dynamic process. If lots of names move beyond their estimates, then volatility will almost certainly rise in the next batch of names, and will keep rising until we hit some sort of equilibrium.

What does this estimate not tell us? Direction. That's a different sort of analysis. I tend to default to "the present trend continues." If a name is trending, I expect it to react consistently with that trend. I would use options volumes and open interest as a bit of a contrarian tell, but only if it tells a different story to the overall trend.

Take AAPL again, for example. The trend suggested up. If the world wanted to play earnings with puts, either to hedge gains or speculate on a miss, I would have found that a very bullish combo. But alas, that wasn't the case, the world wanted them some upside (click picture to enlarge).

Following the money did work this go-around, but I'd be careful using that as a regular strategy. Heavy volume can become a magnet towards a strike, as in this case, but it can also lead to a big reaction in reverse if the masses are leaning one way and the move goes against them.

All in all, there's really no simplistic and magical prediction system that tells you where the stock is about to go. If there was one, everyone would use it and it would stop working anyway. It's all about probability. The magnitude estimate tells you the market expectations. Volume and open interest analysis tells you how investors are playing it. And the stock chart itself gives you a sense of trends and support resistance levels. Throw them all together, consider the overall market backdrop, and you can make some educated guesses.

Disclaimer: Mr. Warner's opinions expressed above do not necessarily represent the views of Schaeffer's Investment Research.