How to Estimate the Anticipated Move After Earnings (or Any Big Event)
Wouldn’t it be nice to know how much a stock is going to move after it reports earnings? Sometimes it’s just a 2% to 3% rally or decline. But other times we can see massive moves of 10%, 20% and more.
But there’s a way to get more insight ahead of the event if you know how to analyze the options chain. Let’s see how it’s done.
Remember the Straddle
Do you remember our talk about straddle trades? If not, refresh your memory with our description. But the basic explanation is this: A trade that involves investors buying a call option and a put option with the same strike price in the same expiration.
Why would someone want to buy a straddle and pay all that premium? Simple, they believe the underlying security will move more than the total premium paid. If Starbucks (SBUX) is trading at $60 and the $60 call and $60 put are trading with a combined premium of $3.00, that means the investor believes the stock will move above $63 or below $57 by expiration.
However, a straddle can also be used (even if not purchased) to see what investors are expecting ahead of a big news event such as earnings, an FDA announcement or pending legal ruling, among other things. Let’s get to the strategy.
Using Straddles to Determine Moves
The picture to the right is from a Kroger (KR) options chain. The company reports earnings in two days and is currently trading near $29.75, thus the put options cost a bit more than the call options.
For simplicity, we’ll take the midpoint of each at-the-money option to calculate the straddle price. In this case that’s $0.65 for the calls — midpoint between $0.60 and $0.70 — and $0.90 for the puts — midpoint between $0.85 and $0.95.
To calculate the expected move, add both debits together just as you would a straddle. In total, the $30 KR straddle costs $1.50, meaning we need the stock to close above $31.50 or below $28.50 by the time of expiration.
Simply take the expected move — $1.50 in this case — and divide it by the strike price. In our scenario, Kroger reports earnings in two days and this option expires in four days. At current prices, investors are expecting an approximate 5% move in the stock.
This is a good time to make note of the expiration. When calculating expected moves, investors should try to use the nearest expiring option contract. In most cases when trading U.S. securities, this will be the weekly contract. If the weekly is not available, the monthly can be used. Investors may want to avoid low liquidity options for risk purposes. However, this method can still be used to determine the estimated move.
When Should I Calculate?
As a final note, investors will want to make this expected move calculation as close to the earnings report as possible. That means figuring out the results with only a few minutes or hours before the close, regardless of whether the stock reports shortly after the close or the next day before the open.
This will give investors the most accurate reading on what the market expects. And it may seem like an unreasonable statement. But say we base our move on Kroger today (Monday), but the company announces its CEO is stepping down on Tuesday. That will undoubtedly change the expected move criteria of the company reporting on Thursday. If we’ve planned or initiated a trade on our now-old data, it may no longer be valid.
So What Can I Do With This Information?
There’s plenty of ways to make use of this info. For starters, you can look up previous earnings moves over the past several quarters. This can found at various outlets online or be noted and saved by the individual investor. Doing so is simple. What’s the one-day move following a stock’s earnings? Keep four to eight quarter’s worth of data for each stock you’d like to follow.
Then, apply the current quarter’s expected move to it. Say for the last six quarters, Kroger stock averages an 8% move. Regardless of which direction the stock moves, the current straddle may be underpriced.
If history repeats, the stock will move 8%, while the current straddle only expects 5%. This means if we were to buy the straddle, we’d look for history to repeat and have an 8% move occur once again. If so, it would represent a $2.40 move in KR stock, more than the $1.50 our trade has currently priced in.
If these events unfold in this manner, it would represent a 60% return on investment.
$2.40 total move – $1.50 debit paid = $0.90 profit.
Max risk = $150
Total gain = $90
Return = $90 / $150 = 60%
The same can be used in the opposite order. Say, the average move over the past six quarters has been just 2.5% for Kroger. This would equate to just a $0.75 move in the stock and would mean the straddle trade pricing in a 5% move would be overvalued.
In this case, investors could consider selling the straddle for $1.50, looking to make a profit of $0.75 or more (up to $150), should the stock fail to have a volatile response.
Keep in mind that the estimated move is just that, an estimate. Sometimes it is dead-on accurate. Other times, it’s off.
More Than One Trade
Knowing the expected move can even help protect investors’ long position and allow them to form a collar trade at the appropriate strikes in order to do so.
Finding an expected move for earnings or any other predetermined event can be very helpful to traders. They don’t have to trade a straddle, but finding the price is necessary to figuring out the expected move.
First, find the date of the event.
Then, use the nearest expiration date that captures the event.
Find the price of the at-the-money straddle, (same expiration, same strike price). Calculate the price as close to the event at possible, but also with a reasonable amount of time to react in case you’re placing a trade based on the information.
Use the total debit to determine the expected move.