By: Costas Bocelli — July 30, 2020
This May Be the Closest Thing to a Crystal Ball
I want you to think back to your first-grade math class for a moment…
In fact, by learning which two numbers to add, you can unlock a wealth of information so eerily reliable that, in many cases, you’ll swear that you’ve got your own crystal ball.
The forecasting technique is used by professional market makers -- who don’t like talking about it with the investing public. They would rather keep this information close to the vest and out of as many investors’ hands as possible.
I first learned about it during my training to become an equity options floor trader on the Philadelphia Stock Exchange back in the late 1990s. It was probably the single most important lesson that contributed to my success.
And here’s the thing…
You don’t have to be a seasoned options trader to take advantage of this information. Heck, even if you’ve never traded one option contract in your life, that’s fine too.
This technique can be applied to thousands of publicly traded companies. Including many found in your own personal investment portfolio. That's what makes it useful even for investors who prefer to trade solely in the underlying stocks.
The forecasting technique that I’m about to share with you is basically designed to help you predict the future price movement of a stock.
I’m going to show you how to find those two numbers you need to add...
… and how the sum of those two numbers can actually help you make better investment decisions.
I’m even going to share a timely example so you can see how the technique works in a real live market setting.
In fact, in a matter of hours, shortly after the stock market closes today, you’ll get a glimpse of how reliable this predictive indicator can be.
You see, we’re in the heart of second-quarter earnings season.
And this is one of the busiest and most important weeks for this earnings cycle.
You see, 167 companies in the S&P 500 and 12 components in the Dow Jones Industrial Average will have reported financial results by the end of this week.
And at the end of trading today, just a few hours from now, we’re going to hear from four of the biggest and most influential companies that can single-handedly dictate where markets are headed next.
I’m referring to Apple (AAPL), Amazon.com (AMZN), Alphabet (GOOGL), and Facebook (FB).
That’s right: All four of these super mega-cap companies will be reporting financial results very soon.
These stocks will be on the move and will most likely influence where markets go from here.
The technique I’m about to share with you can be particularly useful when you want to forecast a potentially significant move in stock price - like when a company announces a quarterly earnings report.
The idea is to try and gauge how big of a move it may be, in advance.
The technique involves identifying the price of an options "straddle" on the underlying stock.
A straddle is simply the value of a Call option plus the value of a Put option that has the same strike price and the same expiration date. A straddle can be bought or sold, but with regard to this technique, we’re simply interested in knowing the fair market value (mid-price or "mark") of the straddle.
Now, here’s the thing…
It’s important to focus on the proper straddle when using this technique.
That's because, in many cases, you’ll find a large menu of options to choose from, so we need to make sure that we target the right ones.
This involves two easy steps:
First, we want to locate the Call option and the corresponding Put option with the strike price closest to the current market price of the stock. These options are considered to be at-the-money.
Second, we need to pick the expiration date.
The closer our expiration date is to the earnings date, the better.
Ideally, you’ll find an expiration date that comes shortly after the earnings event. But what’s very important is that the expiration date captures the earnings catalyst.
The good news is that many widely traded stocks offer weekly options - those that carry a very short expiration periods.
So it’s very common to find the straddle that expires at the end of every trading week.
Now that we know how to locate the most appropriate Call and Put option, we then simply add the value of the two together and... voila! We just priced the straddle.
More importantly, we’ve just unlocked some very powerful information that could predict the potential move of the stock immediately following the earnings event.
You see, the value of the straddle is the breakeven around the strike price for this particular option strategy.
And since we’ve targeted the at-the-money strike price, it’s basically acting like a hidden breakeven around the current value of the stock price.
And because the straddle will expire shortly after the earnings event, that value is essentially pricing in the expected move of the stock.
In other words, we’re able to get a sneak peak of a potential move of the stock based on what the market is implying through the lens of the options market.
This is powerful information!
And here’s the thing…
You didn’t have to trade one option contract or risk one cent to obtain this information.
In fact, option pricing on every publicly traded company that lists options is available for free on popular websites such as Yahoo Finance or Google Finance.
Think about it…
By knowing the potential move, it could help a stock investor better locate a level to place a stop-loss order... or where to place a limit order... or even indicate a price level to buy or sell the stock.
For option traders, this information is very useful. It could help decide which strategy may be most appropriate or help in its construction when choosing the strike price(s).
To get an idea of how effective this technique can be, let’s focus on Apple (APPL), one of the most valuable and widely held publicly traded companies in the world.
As discussed, AAPL will report quarterly results after the close and management will hold an analyst call.
For sure, the stock will be on the move as investors react to the information that will be disseminated.
(Click image to enlarge)
So, where’s AAPL going to trade following earnings?
Now let me tell you this…
This technique isn’t useful for picking the direction.
The stock may have a positive reaction and go UP…
The stock may have a negative reaction and trade DOWN…
Heck, it could just trade sideways.
If someone has a crystal ball that gives you that kind of information, please let me know.
But what this technique can do is tell you how far - up or down - the marketplace expects the move to be.
In other words, it’s a statistical gauge of a measured move.
And in the case of AAPL, the market expects that, following earnings, the stock will move UP or DOWN by 15.50.
How do we know this?
We can get this information by pricing the appropriate straddle.
With AAPL trading at $380.16, we could look to the July 31st 380 straddle (this option expires tomorrow, Friday).
You’d find that it’s trading at $15.50.
So that means that the breakeven is 15.50 points above 380 and 15.50 points below 380.
So we’re looking at a 31 point range (+/- 4%).
In the event of a positive reaction, you’d focus on $395.50.
And in the event of a negative reaction, you’d focus on $364.50.
These are sensitive price points that interested investors will naturally react to, whether they realize it or not.
Now, no financial model is 100% foolproof. But what I’ve found is that straddle breakevens are useful for making investment decisions.
If you want more practice with this technique, you can follow the other three big stocks reporting after today’s close: FB, GOOGL, and AMZN.
Try to price the appropriate straddle.
Then watch the price action, particularly in the after-hours session and throughout the next trading day – you’ll be surprised to see how the breakeven levels come into play.
As a special bonus, I’ve recorded a short video showing you how to locate and price the appropriate straddle in AAPL ahead of today’s earnings report... and how this information can be useful when it comes to making investment decisions.
Click the video below to watch now (click the lower right corner to enlarge the video.)
Until next time!