We know that options tend to be overpriced just before earnings, but how can we quantify the level of overpricing or underpricing? In fact, what is the best way to take advantage of this?
In this post, we are going to walk through a real earnings analysis for Amazon, which reports on July 25, 2019. For reference, I’m writing this on July 22 so I still don’t know what is going to happen a few days from now. The methodology that I follow involves a few steps that I’m going to be developing as you follow along.
The first thing we need to do to figure out if an earnings play is attractive is to compute what is the magnitude of the move that options prices are implying. I know that a lot of people out there uses the price of the at the money straddle of the nearest expiration to get an idea of it, but this is the wrong way of computing the implied move. The ATM straddle doesn’t contain information at all about how much dealers expect the stock to move. The reason is that options dealers price options in a risk-neutral distribution, and also, the price of the options assume continuous hedging until expiration. Using the ATM straddle as a reference for the move is wrong because it assumes that dealers won’t hedge at all until expiration and that assumption is false. However, that doesn’t stop most of the professional press corps out there using the straddle to measure move expectations. I have seen this done in very prestigious publications like the WSJ or Bloomberg.
The best way to obtain an idea of the real implied move is to use implied variance computed directly from options prices and that is how I do this myself. I use the same methodology that is used by CBOE to compute the VIX index, and I apply it to all expirations dates. So if we do that with amazon we get this:
Symbol Expiration VIX 1 AMZN 2019-07-26 48.62 2 AMZN 2019-08-02 35.83 3 AMZN 2019-08-09 31.16 4 AMZN 2019-08-16 29.37 5 AMZN 2019-08-23 28.08 6 AMZN 2019-08-30 27.39 7 AMZN 2019-09-20 26.36 8 AMZN 2019-10-18 26.13 9 AMZN 2019-11-15 23.91 10 AMZN 2020-01-17 27.71 11 AMZN 2020-06-19 28.73 12 AMZN 2020-09-18 28.59 13 AMZN 2021-01-15 29.08 14 AMZN 2021-06-18 28.59
You can see that implied volatility is very elevated for the July 26 expiration which is the day after earnings have been reported and then it starts to decrease the longer we move away from earnings. With this information, we can compute the implied move by using the cumulative property of variance, or better yet we can use the Earnings Tool from the Gamma Central app to do this for us. Applying the methodology to AMZN we get:
Implied move: 4.4% or 87 points at current prices (up or down).
Remember that the implied move doesn’t tell us anything about direction, only that options are priced as if AMZN will move 87 points up or down the next day. This information is useful because we can now compare it with historical moves after earnings and see if options are overpriced or not with respect to previous cycles. We can get historical earnings information from public sources like the EDGAR database, from the SEC, or again, we can just use the Earnings Tool from the Gamma Central app. In this case, the information shows the following:
Mean move after earnings: 5.95%
Standard deviation: 4.22%
Right from the numbers, it looks like AMZN options are being underpriced with respect to the historical mean for some reason. Even more, if we include the standard deviation that shows that sometimes AMZN has moved quite a bit above the mean. This piece of information is also very interesting and it is pointing to some complacency on the part of options dealers, they seem to think that AMZN won’t move much after the report but that doesn’t align well with historical precedent and in fact, we can compute the following probability:
Prob move is within implied parameters = 35.9%
What the probability is telling us is that is very likely that AMZN will move more than 87 points after earnings and that looks like a tremendous edge for a nondirectional play. We just need to design a trade that profits nicely if the stock moves more than the 87 points implied. But before all of you go out and start looking at options, remember that there are still a couple of this before earnings and the situation can change a lot just before them.
This example was done just to illustrate a good earnings analysis before designing a trade. Remember that there are no magic recipes and we always have to assume risk in order to make money. But at least knowing where options dealers stand and the odds involved in the bet will provide us with some edge when designing the trade itself. And that is exactly what I’ll do in my next post. Stay tuned!