How Options Can Predict Earnings Moves

04/14/2010 12:01 am EST

Focus: OPTIONS

JPMorgan Chase & Co. (JPM) is due to report first quarter results on Wednesday before the market opens, with consensus estimates for net income of $2.93 billion, or 64 cents EPS, according to Thomson Reuters. That would be a decline from fourth quarter 2009, which saw profits of $3.28 billion, or 74 cents EPS.

Bloomberg reported this morning that this expected pullback in earnings is due to losses on credit card portfolios and home loans. “Mortgage write downs may be as high as $2.5 billion per quarter during 2010, compared with $8.3 billion in all of 2009, according to company data,” writes Dawn Kopecki in her story posted on Bloomberg.com at 8:01 am ET.

Key issues facing big “bulge bracket” banks like JPM are credit quality and problem loans, but much of this had been priced in to the bank’s shares up to this point. The stock price rise off the credit crisis lows of $15 last year to the mid-$40 area now has been accompanied by enough earnings recovery—from only 40 cents EPS a year ago—to support a sub-20 P/E multiple.

From the Bloomberg story:

Analysts including Anthony Polini at Raymond James & Associates said they will be watching to see if Chief Executive Officer Jaime Dimon was able to reduce provisions against future credit losses as a gauge of whether the worst of the U.S. housing crisis is over.“The key factor for this quarter for banks will be to say reserve builds are largely behind us and the outlook for lower problem loans and loan losses have improved for the second half of the year,” Polini said. “It’s the outlook that matters.”

On the positive front for JPM, the bank is able to sustain losses in the consumer credit/mortgage parts of its business with trading revenue, especially in the fixed income area, which Credit Suisse analysts see as adding $1.9 billion to the top line versus the fourth quarter. And in his annual letter to shareholders last month, Dimon said the bank may be able to eventually boost its dividend on continued improvement in the economy and reduced levels of charge-offs.

What Are the Options Markets Saying?

We know what the analysts expect from JPM, but that’s not always enough. There are two handy ways that options can tell you what the market is expecting in terms of possible price movement before an earnings event. The first is the at-the-money (ATM) straddle for front month options, which is simply the combined price of the call and the put with strikes nearest to the price of the stock. Monday night, with JPM closing at $46.14, the April 46 straddle was trading around $1.55.

Now let's take a look at some chart graphics built with the Profit & Loss Calculator, part of the Click HereOptionsHouse Trading Tools suite.

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Click to Enlarge

Tuesday morning, the April 46 straddle has slipped ten cents to about $1.45, with the stock up to $46.25. Traders who buy a straddle are betting that a stock’s move will be bigger than the total amount paid. So, in this case, if you thought that JPM volatility after earnings could send the stock above $47.50 or below $44.50, you would be willing to pay about $1.50 per straddle. These April option are especially sensitive to JPM earnings tomorrow because they expire two days later.

The above screenshot of the profit and loss calculator is just a static view of part of the tool. The actual P&L calculator is an interactive option trading tool that allows you to dynamically simulate the risk/reward of dozens of option strategies with variable inputs of time, price, and volatility. I consider it the single best way to learn about options, simply because we learn best with visuals that we can also interact with.

The other great way to let option markets tell you what kind of move to expect for a stock is to look at the implied volatility of the second-month options. Below is a diagram of a bell curve distribution of possible stock price movement and the equivalent standard deviation that May options imply.


Click to Enlarge

These possible JPM movements implied by option prices and volatility are still just estimates. You can think of them as risk-adjusted bets by thousands of option market participants, all with some vested interest in the movement of JPM shares.

By Kevin Cook of ONN.tv

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