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The earnings season starts big time this week with several large companies including Google (GOOG), Yahoo (YHOO), Goldman Sachs (GS), EBAY (EBAY), and IBM (IBM) making announcements. GOOG is particularly interesting because the stock has run up considerably in the last quarter, gaining over 15% since its last announcement in April.

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 call it the Expectation Model. Basically, I examine recent stock price activity, estimates vs. whisper numbers, past post-earnings price changes vs. results, current RSI levels, and come up with a measure of whether expectations are unusually high or low.

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. (Unusually low expectations are generally less predictive of higher post-announcement prices, however - unusually high expectations more reliably predict lower prices after the announcement).

Here is the record of how GOOG has responded to earnings announcements over the last year (with the price change from just before the announcement until the Friday close after the announcement when the weekly options expired):


(Click to enlarge)

The company has managed to beat estimates every quarter, and the stock has moved higher every time except once when they barely exceeded estimates last October. In the three quarters when the stock moved higher, the average gain was 4.9% which would translate to about $45 at today's price of $926 as I write this.

Option prices are predicting a move of $44, almost exactly the average gain over the past three gaining quarters (but far more than the average change of $29 over the past four quarters).

This time around, expectations seem to be unusually high. Whisper numbers are higher than estimates, ($11.29 vs. $10.81), and the stock has enjoyed a dramatic run-up going into the announcement (and reaching a new high today). Check out the chart:


(Click to enlarge)

Note that the time when the stock soared over $50 after announcing (January of this year), in the month going into the announcement the stock had dipped a little, an indication that expectations were running low at that time, so when earnings bested estimates, there was a big run-up in the stock.

This time around things are far different. Expectations are sky-high. (RSI numbers add even more support to this notion - at 98 and in a "very overbought" condition.) Even if actual earnings are much higher than estimates and whisper numbers, it is doubtful to me that the stock will trade significantly higher after the announcement, and there is a very good chance that it might trade much lower if any part of the announcement (earnings, revenues, margins, or guidance) disappoint in any way.

Bottom line, if you would like to own Google, I would wait until after the announcement to make your purchase. If you are an options nut like me, I would buy a diagonal call spread with the buy side higher than the Jul-13 calls you sell short. I have bought Aug-13 925 calls and sold Jul-13 920 calls which results in this risk profile graph (assuming IV for the August options falls from 26 to 21):


(Click to enlarge)

These positions should make a gain if the stock does not gain more than $30 after the announcement or fall by more than $50 which seems like a fairly wide range to me. There is a $2500 maintenance requirement for the 5 spreads plus the cost of about $1800 for the spreads, and if the stock falls about $20 which is my best guess, a $3000 gain could come along.

Google has been a great stock to own if you could handle the wide fluctuations over the years, but it feels to me that it has gotten a little ahead of itself right now, especially since it has picked up over 15% since the last earnings announcement. The gain since the day before that announcement has been over 20%, a huge amount for a fairly mature company to chalk up in a single quarter.

While I believe that the stock is more likely to trade lower after the announcement than it closes at on Wednesday, there is a chance that it might move higher between now and Wednesday's close, as that is often the pattern for companies when expectations are unusually high as they are now.

Source: How To Play The Google Earnings Announcement This Week