How to Predict Earnings with Options

05/25/2011 5:00 am EST

Focus: OPTIONS

This simple, three-step process can be used each earnings season to gauge a stock’s likely movement and then either capitalize or hedge risk using an appropriate options strategy.

A favorite quote of traders, the famous physicist Niels Bohr once said that "Prediction is very difficult, especially about the future." While true for many aspects of quantum mechanics, traders and investors have several tools to help make accurate predictions in the financial markets.

Oftentimes, these tools are derivative financial instruments that can help provide an aggregate picture of future market sentiment—tools like options.

Such predictions can be particularly useful for active traders during earnings season when stock prices are most volatile. During these times, many traders and investors use options to either place bullish bets that leverage their positions or hedge their existing positions against potential downside.

Step 1: Analyze the Chain for Opportunities

The first step in analyzing options to make earnings predictions is to identify unusual activity and validate it using open interest and average volume data. The goal in this step is to find some specific options that may be telling for the future and create an initial list of targets for further analysis.

Finding these target options is a two-step process:

  1. Look for the Unusual: Look for call or put options with current volume that is in excess of the average daily trading volume, particularly in near-term months
  2. Compare Open Interest: Make sure that the current volume exceeds the prior day's open interest, which indicates that the current day’s activity represents new positions

In Practice: Baidu.com (BIDU)

If you visited an options analysis page for Baidu.com (BIDU) a couple weeks ago, you would have found an options chain like this:

chart
Click to Enlarge

Notice that the highlighted near-month call options were trading with volumes significantly higher than their open interest, which suggested that the options were being accumulated by traders and/or investors.

We could also look at the current day's volume and compare it to the average daily volume to draw similar conclusions, but open interest is generally considered to be the most important to watch.

NEXT: Step 2: Determine the Magnitude with Straddles

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Step 2: Determine the Magnitude with Straddles

The second step in analyzing options to make earnings predictions is to determine the magnitude of the anticipated move.

Since most options appreciate in value when volatility increases, implied volatility can tell us when the market is anticipating a big move to the upside or downside. Luckily, straddles are designed to take advantage of implied volatility, so we can use them to calculate an exact magnitude. (To learn more about volatility, see Option Volatility Made Simple.)

Straddles represent an options strategy that involves purchasing call and put options with the same strike price and expiration date. By purchasing an at-the-money straddle, options traders are positioning themselves to profit from an increase in implied volatility. Therefore, looking at the price of the at-the-money straddle can tell us the magnitude of this implied volatility.

In Practice: Google (GOOG)

If we purchase one at-the-money Google (GOOG) call option for $1,200 per contract and one at-the-money GOOG put option for $1,670 per contract, then the cost of the at-the-money straddle will be $2,860, plus any commissions paid.

With Google shares trading at $575.50 per share, this means that we can expect a move of approximately 5%, or $2,860 / ($575.50 x 100).

The at-the-money straddle for GOOG will then look something like this:

chart
Click to Enlarge

NEXT: Step 3: Decide on Hedging or Leveraging

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Step 3: Decide on Hedging or Leveraging

The third and final step in analyzing options to make earnings predictions is to determine the direction of the move.

While we only really have access to trading volume, we can use the bid and ask prices and trading data to make fairly accurate assumptions. Simply put, trades hitting the bid price are likely selling transactions, while those hitting the ask price are likely buying transactions.

Traders and investors can also look at the option chain for various types of options strategies that are most likely to occur around earnings season. For example, similar volumes in put and call options in the same price and expiration dates may signal a straddle bet on volatility, while call options being sold could indicate long-term investors hedging their positions by selling calls—a bearish indicator.

Traders and investors can find this information by looking at real-time trades through their brokerage platforms or by using one of many Web sites that provide real-time trading information; or by simply using delayed data from other Web sites.

Bottom Line

While using options data to predict earnings moves may be part art and part science, many financial experts find it invaluable when predicting not only earnings moves, but also mergers and acquisitions and other anticipated price movements.

See Related: Using Options to Trade Takeover Talk

Using this simple three-step process, you can make your own earnings predictions using options data:

  1. Identify unusual options trades and validate them by comparing the current day's volume to the open interest and/or daily trading volume
  2. Determine the magnitude of the move higher by calculating the cost of an at-the-money straddle, which provides an idea of anticipated volatility
  3. Discover the direction of the trade by looking at the bid and ask prices, as well as analyzing the overall option chain to look for the potential types of trades being placed

As you put this technique to use, you'll find that the future becomes much easier to predict.

By Justin Kuepper, contributor, SECInvestor.com

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