Earnings season here in the U.S. got off to a bang with upside price explosions last week in Netflix and Google and decent results from banks that also drew in buyers. Expectations were not particularly high as recent strength in the dollar, and macro goings on were weighing on investor sentiment for weeks. That negative sentiment caused downward earnings revisions throughout Q2, per FactSet:
- Earnings Growth: For Q2 2015, year-over-year earnings for the S&P 500 are projected to decline by 4.4%. The last time the index reported a year-over-year decrease in earnings was Q3 2012 (-1.0%).
- Earnings Revisions: On March 31, the estimated earnings decline for Q2 2015 was -2.2%. Seven sectors have lower growth rates today (compared to March 31) due to downward revisions to earnings estimates, led by the Industrials sector.
As a trader who is pretty focused on the use of equity options, earnings periods, 4x a year, present opportunities typically more exciting than the other 8 months of the year. However, as regular readers know, with a defined date event comes much higher prices for options. What we try to do for the most part around earnings, is avoid outright directional bets using long premium, because there are a lot of things you need to get right, given the rise in implied vol to just break-even, direction, magnitude of the move and timing. But sometimes we lose our discipline and find a trade set up (with defined risk) as somewhat irresistible, as we did with NFLX last week (read here). That’s gonna happen from time to time and it was a mistake, but hopefully not often. But for those trying to gain clues from the options market into earnings events I think the most important take-away is what story is being told in the options prices. themselves and whether that story is true.
For instance, from our NFLX preview last week, I concluded:
while the implied move is lower than the average move, it is important to note that while the implied move looks cheap to the average historical move, for the last two quarters the implied move has been about 10% the day of the report, and the stock has rallied 18% and 17% respectively.
Once again, options traders priced the implied move in either direction of 10%, and the stock gained 18% the day following results. For three straight quarters options traders priced what in most stocks would be an eye-popping 10% one day move, and in all three instances the stock’s actual moved nearly doubled the implied. Next qtr I suspect we will not see a repeat.
With NFLX I was just plain wrong on direction. But in GOOGL what was frustrating is that my view of options prices was spot on (that they were priced too cheap in either direction), but I didn’t pull the trigger, from preview:
The July 590 straddle (one day) looks cheap to me at $21, for stone cold gamblers, it looks like a scoop.
For those with a directional view the July 590 calls and the July 590 puts offered at $10.50 (stock ref $590) look very cheap with a break-even down 1.8% at $579.50, or up 1.8% at $600.50
The stock rallied 16% on Friday, more than 4x the implied move, and the at the money straddle referenced above was worth $100 on Friday. WHOA. The stock gained $70 billion in market cap in a snap.
Trading options around earnings is about as tricky as it gets. In the situation of NFLX, long premium long biased directional for a massive implied move was the right trade, and for GOOGL, long premium, long biased directional for a very cheap move was also the right trade. Obviously, these two situations looked easy in hindsight. But both stocks had something that indicated ahead of time.
In the case of NFLX it was that history of one day moves as well as the fact that the stock had doubled on the year and threatened another parabolic breakout (these breakouts tend to outperform the move as sellers (disappear). And in the case of GOOGL, when CC and I were discussing it beforehand we both noted how the stock has seemed to become “unhinged” in the days leading into the event. After having spent months in a 20-30 dollar range the stock suddenly ripped 50 dollars higher in a straight line in the days before earnings, taking the stock up to resistance and at the same time taking out a ton of sellers into the event.
That set up perfect conditions for the sort of breakout we saw and the options market simply hadn’t adjusted in those days beforehand.