Analysts often talk about the expected movement in a stocks’ share price based on an upcoming earnings release. They are referring to the stock’s implied trading range, which is calculated by reverse engineering the option pricing formula.
Traders typically use some version of the Black-Scholes options pricing model to calculate the theoretical fair value for a call and a put on the underlying stock. The calculation uses inputs such as time to expiry, current stock price, strike price, risk free rate of return, as well as the expected dividends payable by the underlying stock and, of course, volatility. The last input is the variable – that is, the best guess – in the pricing model.
Instead of calculating the fair market value, you can input an option’s current price and ask the model to solve for volatility. When analysts tell us that an upcoming earnings release is implying a 10% move up or down, they are basing that assessment on this implied volatility calculation.
Another way to approach this is to add and subtract the per share value for the near term, the at-the-money straddle, on the underlying stock from the at-the-money strike value. (A straddle is the simultaneous purchase or sale of a call and a put at the same strike price with the same expiration date.)
The buyer of a straddle wants the underlying stock to move far enough to cover the cost of both options, while the seller wants the underlying stock to trade within a range bounded by the total premium collected.
But, in both cases, the trader is making a bet on the expected volatility prior to the options expiry. A straddle is not a directional bet on where the stock is expected to go.
For some perspective, I will look at Facebook Inc. (symbol: FB), which reported second-quarter earnings on July 27. The consensus second-quarter price estimation was US82¢ per share, which Facebook ultimately blew past, posting earnings of US97¢ per share.
Analysts have struggled to pinpoint Facebook’s engagement among its users. That leads to an expansive range of earnings estimates and, by extension, a wide implied trading range for the stock just prior to the actual release date.
Traders use near-term options to calculate this projected trading range. Looking back to a couple of weeks preceding the July 27 numbers, Facebook options expiring on August 5 were implying a 5% trading range at the point of the actual earnings release.
So, let’s put some meat on this bone. During the two weeks preceding the earnings release, Facebook was trading around US$118. The Facebook August 118 (at-the-money) straddle was trading around US$8.60, which was the option market’s best guess for an implied trading range on Facebook based on the variability of the earnings estimates.
The implied trading ranges is calculated by framing the strike price (US$118) with the total cost of the August 5 straddle. In the two weeks leading up to the release date for quarterly earnings, Facebook’s implied trading range was US$109.40 (US$118 strike price minus US$8.60 = US$109.40) and US$126.60 (US$118 strike price plus US$8.60 = US$126.60).
Another way to say the same thing: Facebook options are implying a 7.3% swing in the stock price, based on the potential variability of earnings.
Other companies have much wider implied trading ranges, which reflects the uncertainty around the earnings numbers.
Over the same time period used in the Facebook calculation, Teck Resources Ltd. (symbol: TCK) was trading at around $17.50 per share and the TCK at-the-money straddle was fetching $2.50. That translates into an implied trading range of $15-$20 per share.
Coming full circle, Facebook traded up to US$128.33 the day after the blowout numbers, while TCK soared as high as $20.81 after the firm’s July 28 earnings release.
Strategically, companies do their best to guide analysts to a reasonable expectation. The objective is to set estimates at the lower end of a range so that management can deliver above expectations. It’s easier for company executives to take a congratulatory lap than to try to explain a “failed” quarter.
And because companies do such a good job of managing expectations, there tends to be a bullish bias leading up to the earnings release date.
But that said, there are macro factors beyond the control of company management. For example, how regulatory restrictions affect a banks’ ability to lend, foreign currency fluctuations, fuel costs for transportation companies and weather patterns that affect traffic flow in retail stores all fall within this broad category.
On the other hand, companies such as utilities and blue-chip telecoms have relatively stable earnings streams, allowing management to provide guidance that is, more often than not, within basis points of the anticipated number. And this gets reflected in the implied trading range for the stock.
As we move into second-quarter earnings, traders can use options to ascertain an implied trading range, then set up options strategies that provide a potential payoff based on whether the company matches, beats or misses its earnings per share expectations.
As we near the end of the second-quarter earnings season, this might be a good time to set up trades for the third quarter. I would expect Facebook’s blowout in the first and second quarter will lead to an expanded implied trading range as we get closer to the release date for third-quarter earnings.
There may be an opportunity to take a short-term trade based on your expectations vs consensus estimates. Buying calls if you think analysts have understated the potential – or puts if you think estimates are overstating the anticipated results.
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