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Abercrombie & Fitch (NYSE:ANF) announces earnings on Friday, May 24, 2013 before the market opens. This is a little scary for option traders because the weekly options will be in play for only one day before they expire.

ANF describes itself as a specialty retailer of casual apparel for men, women, and kids (although I could never figure out how you can specialize in all three at the same time). Market cap $4.24B and most recent closing price $54.24. Trailing P/E 19 which is slightly higher than competitors American Eagle Outfitters (NYSE:AEO) and The Gap (NYSE:GPS) who have a P/E of 17.

Institutional investors have sold nearly 34 million shares over the last quarter (source: Yahoo) which amounts to about 44% of the outstanding shares. While this is a disquieting statistic, the company pays a well-protected 1.5% dividend (payout ratio only 25%) which helps protect against a huge drop in share price after the announcement.

Here are the results for the past four quarters, with the stock price change from the close on the day before the announcement until the closing price on Friday (when the weekly options expire):

(click to enlarge)

The company's stock price has taken some huge moves after earnings announcements over the past four quarters - a whopping 16.9% average change. While the company bested estimates every quarter, they were only rewarded by a higher stock price in two of the four quarters. In my opinion, that was due to the expectation levels that existed at the time.

Over the last several months, I have been testing the proposition that the level of expectations prior to an earnings announcement is a better indicator of what the stock price will do than the actual earnings themselves.

I have been using the following indicators to determine whether expectations are unusually high (or low) leading up to an earnings announcement and what the stock price is likely to do after the announcement:

  1. Stock price action in the most recent weeks.
  2. Whisper numbers vs. analyst estimates.
  3. Recent post-earnings price changes compared to earnings results (is there a pattern for that company)?
  4. Current RSI levels.
  5. Overwhelming positive (or negative) comments on various blog posts.

If expectations are usually high, there is an excellent chance that the stock will be flat or fall after the announcement, regardless of how much the company might surpass estimates, and conversely, the stock is more likely to move higher when expectations are low, even if estimates are merely met.

In addition, I have checked out recent hedge fund activity (are hedge funds buying or selling the stock?) to get a better handle on whether the stock is likely to rise or fall after the announcement. While hedge funds are not always right, they can be counted on to have conducted some serious due-diligence work before making a decision to commit or divest, and they have far more resources at their disposals than any individual could hope to have.

I have had some success with this model, including eight consecutive winning pre-earnings calls without a loss - see results.

In trying to guess what will happen to ANF when they announce next Friday, one of the most significant numbers to me is what happened in the week prior to the 11/14/12 announcement. The stock fell by over 10% leading up to the announcement, indicating that expectations were quite low, and any surprise on the upside would result in a big upward move. That is exactly what happened - the stock made a huge 31.1% gain, a move that would have been unlikely if expectations had been high at that time.

Since the beginning of April, ANF has steadily climbed higher - about 20% - and just recorded a twelve-month high. Check out the chart:

(click to enlarge)

This recent stock action is a strong indication that expectations are unusually high at this point in time. (Reliable whisper numbers are not available.) Because of these high expectations, it seems unlikely to me that will be a large move to the upside after the announcement, and a good chance that the stock will trade lower. When expectations are this high, something in the announcement might disappoint - if not earnings, perhaps revenue, margins, or guidance.

My position is supported by the large amount of institutional selling over the past quarter (it's usually foolhardy to bet against the pros) and the fact that the past two quarters when a double-digit change took place were both on the upside. History has shown that subsequent big moves were usually in the opposite direction (if big moves, indeed, took place). RSI is also at an elevated 79 (overbought) although overbought conditions are less reliable indicators than oversold conditions.

If someone likes ANF, I suspect they might get it at a relative bargain price if they waited until after the earnings announcement to buy, or they might sell a naked out-of-the-money put to collect some premium and also get stock at a lower price than today's $54.24.

Being an options guy, I plan to take advantage of the escalated option prices for the May4-13 weeklies which carry an implied volatility (IV) of 83 compared to 48 for the June-13 options. I will buy June-13 52.5 straddles (buying both puts and calls) and selling an equal number of May4-13 (expiring 5/24/13) strangles - 49 puts and 55 calls. These positions create the following risk profile graph which assumes that IV of the June options will fall from 48 to 38 after the announcement (investment of less than $4000):

(click to enlarge)

The graph shows that the stock can move higher by about 5% before a loss is incurred or it could fall as much as 15% and still make a nice gain (and anywhere between those limits should be profitable). A gain of about 20% should result at any closing price between $48 and $56 (current price = $54.24) and a gain of some sort if the stock ends up at any price between $43 and $58. That seems like a fairly large break-even range.

It will be interesting to learn if this will be my ninth consecutive successful earnings announcement play and provide further support to my hypothesis that expectations prior to the announcement plays a primary role in the direction that the stock price moves after the announcement.

Source: How To Play The Abercrombie & Fitch May Earnings Announcement

Additional disclosure: I plan to initiate the neutral - bearish option positions on ANF as outlined in the article.