By: Costas Bocelli — April 29, 2021
Knowing How Much a Stock Will Go Up or Down is Priceless: Here's How to Do It
Alphabet (GOOGL), Microsoft (MSFT), Apple (AAPL), and Facebook (FB) already released their quarterly results. And Amazon (AMZN) -- possibly the biggest, most influential company on Earth -- one will do so at the close of trading today.
Analysts really never doubted that any of them would report positive revenue and earnings per share (EPS) growth. It was just a matter of how much.
After all, during COVID-19, these firms beefed up their bottom lines by giving consumers and businesses some desperately needed things during the crisis. Things like computers and software.
No one expected that momentum to screech to a halt in 2021.
True to form, the four didn’t disappoint. They all handily beat estimates. (And the fifth will likely have done so by the close of trading today). And while the group’s earnings beats were largely predictable, the market’s reaction was not.
On the day following its announcement, GOOGL rose nearly 5%, while MSFT dipped 2.8%. In after-hours trading, shares of AAPL were up 3%, and FB popped 6% to new all-time highs.
You can chalk up these wishy-washy price movements to the fact that a company’s forecasts for the future are only as strong (or as weak) as investors perceive them to be.
These five stocks represent more than 20% of the entire market cap of the S&P 500 large-cap index. For that reason, they carry a lot of weight when it comes to impacting today’s market climate and whether it heats up or cools down over the next few months.
And so far, it’s sunny and warm on Wall Street.
Of the 150 or so companies in the S&P 500 that have already reported, 84% boasted a positive EPS surprise. And according to FactSet, they have beaten expectations by a combined 30%, up from an average 7% five years ago.
It's no coincidence that the Dow Jones Industrials and S&P 500 are setting record highs at the same time.
However, with the bulk of company earnings still outstanding, a lot of "ifs, ands, or buts" remain.
And what we hear from Amazon.com at the end of trading today—and the others to follow in May--could impact how other stocks perform and ultimately dictate where markets are headed next.
If only we could say with relative certainty how big an impact earnings for the companies yet to report will have on their stock prices.
Wishful thinking, right?
I’m going to share with you a technique you can use 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 both have the same strike price and the same expiration date.
A straddle can be bought or sold. But for 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 easy to find straddles that expire 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 single option contract or risk one red 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, you could better locate a level to place a stop-loss order... or place a limit order... or even find a price at which 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 them choosing the strike price(s) when putting the strategy into action.
To get an idea of how effective this technique can be, let’s focus on Amazon.com (AMZN), one of the most valuable and widely held publicly traded companies in the world.
As discussed, AMZN will report quarterly results after the close of trading today, 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 any image to enlarge)
.So, where’s AMZN 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 AMZN, the market expects that, following earnings, the stock will move UP or DOWN by $146 per share.
How do we know this?
We can get this information by pricing the appropriate straddle.
With AMZN trading at $3,458.50, we could look to the April 30th weekly 3,460 straddle. These options expire tomorrow, Friday the 30th.
You’d find that the straddle is trading at $146.
Which means the breakeven is 146 points above 3,460 and 146 points below 3,460.
So we’re looking at a 292 point range (+/- 4.2%).
In the event of a positive reaction, you’d focus on $3,606 per share.
And in the event of a negative reaction, you’d focus on $3,314 per share.
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 better, more informed, investing decisions.
It never hurts to have a little known "floor traders trick" up your sleeve for that.
Until next time,