Have you ever listened to CNBC on a marquee company earnings day and heard something along the lines of “options are pricing in a 4% move in this stock post-earning, either up or down” and wondered how that was calculated? Here is how I do it:
Yesterday (5-2-2017) Apple (AAPL) reported Q1 earnings of $2.10 per share. It was one of those scenarios where earnings beat expectation, but guidance was weak, so the stock opened the next day down 1.49%. How close did that 1.49% on Wednesday match what the options market told you on Tuesday?
First, start with the shortest term option available. Options always expire on a Friday, so for AAPL you need to look at the options that expire on 5-5-2017. Prior to close on Tuesday AAPL was trading at $147.63 per share. Look at at-the-money calls and puts – so look at the $148 call. That option was trading on 5-2 at $2.41
So that means a bullish speculator (3 day options is definitely speculation, not investing!) believes AAPL will get to at least $150.41 by Friday. There are only two things at play between Tuesday and Friday — 1 is the earnings call (obviously) and 2 is the overall market volatility on Wednesday through Friday. So a speculator believes those 2 forces will equal a total move of 1.88% (the difference between 150.41 and 147.63).
Now look at the way the options were trading on Wednesday morning. With the stock now at $145.31 a call for $146 on Friday expiration was trading at $0.80. Again this implies a break even price of $146.80, or a 1.02% move. The only thing from Wednesday to Friday is normal overall market volatility, so this tells you that Wed-Fri market vol accounts for 1.02%.
Doing the math on the only other force at play (earning announcement) means that the earnings announcement was 1.88% – 1.02% = 0.86%
Let’s do it now for the downside using at-the-money puts. The Tuesday $147 put cost $2.27 implying a break even price of $144.73 or a move down of 1.96%.
On Wednesday the $145 put cost $1.34 implying break even at $143.66 or a move down of 0.92% between Wednesday and Friday.
Doing the math, 1.96%-0.92% = 1.04%
So the options told you to expect a 0.86% move up or a 1.04% move down in AAPL post-earnings.
So really the options did an okay job of predicting the move. The predicted downside move was 1.04% and the actual was 1.49%. Kinda close, but not spot on.