Part1: It was a low key earnings season - or was it?

by Wayne Ferbert on September 3rd, 2013

At Buy & Hedge, we watch the earnings season very closely. Mostly, because we simply believe a company is worth a multiple of its earnings power. So, following the overall market, sector, and company earnings power is part of the equation for determining VALUE!
 
As options traders, we often examine the options markets on companies around their earnings. The reaction in a company stock in the trading day immediately following its earnings release is always an interesting science to examine.
 
The earnings announcements can serve to verify what the market thinks is the company’s earnings power – or it can totally re-shape the view of the company’s earnings power. If the earnings verify the earnings power, then you end up seeing small movements in the stock on earnings day. If the company surprised in its earnings, you tend to see the bigger move in the stock price.
 
But that move can be either up or down – depending on whether the earnings surprise was to the upside or the downside. The options market tends to capture the expected range of what the stock might move in the time value in the options prior to earnings. In fact, the time value that ERODES from the options immediately after earnings is significant. Why? Because the market knows as much as it is going to know on that day - until the next earnings in 3 months. 
 
Imagine the market maker on the options for an underlying stock like Microsoft (MSFT). No one knows whether the earnings are going to surprise or not. The SEC requires Microsoft to keep that information secret until earnings announcement. Since the market doesn’t know, it will price in some ambiguity in to the time value in the options that are near-the-money or at-the-money.
 
For larger companies like MSFT, surprises are not that common – and therefore the options premiums before earnings are not as high. MSFT is a large cap company with low price volatility also – so its options are always cheaper than say – Salesforce.com.
 
This past quarter, MSFT did surprise to the downside – as they disappointed with the sales of their new tablet PC. So, the stock plummeted. And anyone owning the put options did very well. But MSFT, as a big mover, tended to be the exception this last quarter.
 
Let’s be more accurate – a big move on earnings is ALWAYS the exception to the rule. But quarter after quarter, you expect to see a certain number of big stock movers on earnings. This quarter, we did not see as many as last quarter.
 
The absolute value of the average stock move on earnings day for this past earnings season was 3.8%. This is the daily move for all stocks that TRADE options AND had a stock PRICE greater than $10. The standard deviation was 4.4%. See the distribution chart below:
For the earnings season for the 1st calendar quarter, the average absolute value of the stock on earnings day was 4.4% with a standard deviation of 4.7%. This is a material difference between two quarters across over 1400 stocks. Here is that distribution:
Note how the more recent quarter just looks like half of a normal distribution with a strong weighting around what would be the center. Meanwhile, the Q1 earnings season had more distribution away from the 1 and 2% movement ranges.
 
Q1 had more big movers on earnings than Q2 had. But in the end, the more important question would be: what did the market expect? Let’s examine that in Part 2 on Thursday’s blog.


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