Dr. Terry Allen's  Instablog

This is the second article covering companies who report earnings during the week starting April 22, 2013. The first article - 3 Earnings-Related Plays For Next Week - included the companies which report before Wednesday, April 24th, and today the rest of the companies are covered.

For several months I have been studying ways to predict stock price action after an earnings announcement using four measures:

1. Whisper numbers vs. analyst expectations
2. Stock market action leading up to the announcement
3. The percentage change predicted by option prices vs. historical post-announcement changes
4. The implied volatility (IV) advantage of the Weekly options over the next-month out options (this is also a good indicator of how much the further-out options will implode in value after the announcement).

The basic premise is that if expectations are unusually high, there is a very good chance the stock will fall after the announcement, regardless of how much the company beats analyst expectations on earnings, revenue, margins, and guidance. There seems to be a large group of investors who "sell on the news" and at least temporarily depress the stock when expectations are particularly high going into the announcement date.

If expectations are unusually low, the reverse is true. The stock may well move higher even if the company fails to meet analyst projections.

Last week, these expectation measures suggested that SanDisk (SNDK) had extremely high expectations and would likely fall after the announcement, regardless of what the numbers were. The bearish option spread I recommended in How To Play The First Week Of The April Earnings Season ended up gaining 68% after commissions - see details.

As high as SNDK's expectations seemed to be, Google (GOOG) had equally low expectations. In one of our portfolios at Terry's Tips, with GOOG trading about $770, we bought May - April calendar spreads at the 780 and 790 strike prices, paying $4.60 and $4.75. In the morning after the announcement, we sold these spreads for $11.52 and $11.80, more than doubling our money. Once again, our measure of expectations correctly predicted the direction the stock price moved after the announcement.

Apple (AAPL) seems to have as low expectation levels as GOOG did a week ago. This would suggest the outright buy of AAPL in advance of Tuesday's after-hours announcement, or May - Apr4 calendar spreads at higher strikes than the $390.53 current price (e.g., at the 400 and/or 410 strike prices) where calendars can be bought for less than $4. These spreads could easily be worth double those amounts if the stock moves moderately higher next week after the announcement.

Here are the numbers for the remaining companies (trading over $20) with Weekly options that announce next week:

(click to enlarge)

While you may use this information to support or refute ideas you may have about these companies, there does not seem to be a strong indication for any of these companies that expectations are particularly high or low. That is a real shame since I spent many hours calculating these figures.

Occidental Petroleum (OXY) and Qualcomm (QCOM) have whisper numbers which are higher than analyst expectations by the largest margins of any of the other reporting companies, but both companies have traded much lower over the past week and month, suggesting that expectations are not unusually high in spite of the elevated whisper numbers.

Of the nine companies reporting, Starbucks (SBUX) might be the one with the highest expectations (and might be most likely to trade lower after the announcement). Whisper numbers are slightly higher than analyst expectations, the stock has moved higher over the last month, and it fell only 0.1% last week while the S&P 500 fell by 2.1%. However, unless you have other reasons to believe that SBUX is due for some weakness, this level of expectations is not sufficiently strong to suggest a short sale, at least compared to the high levels we saw in SanDisk last week and low levels displayed in AAPL and GOOG.

One interesting note is that many companies, notably Baidu (BIDU), F5 Networks (FFIV), and Amazon (AMZN) have option prices which are quite low compared to the average historical change in the stock price after the announcement (according to EarningsWhispers.com). You could buy a straddle for the percentage of the stock price (Option Volatility column) and make a gain no matter which way the stock price moves just as long as the percentage change is the same as the historical average.

Another way of playing this would be to use the information that option prices for these companies seems to be lower than they should be to pick a direction if you like or dislike a particular company's prospects, and buy either a put or a call. For example, I think AMZN is having difficulties right now, and selling the stock short or the outright purchase of a put might be in order. Even with that inclination, I would be more comfortable buying a calendar spread at a lower strike price because I don't really feel that strongly about the stock moving lower at this particular earnings announcement.

I continue to believe that checking out the level of expectations prior to an earnings announcement is a great way to predict the direction the stock price might take after the announcement (regardless of how good or bad those numbers might be). In order to get a handle on the level of expectations, you have to go through the process of measuring the variables as I have done in the above table.

There is surely some value in concluding that there is not a clear edge to be had in either direction based on these calculations (as we have discovered in the above table), and as long as there is interest from Seeking Alpha readers, I will continue to make these calculations and pass them along to you.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

We call them PEA (Pre-Earnings Announcement) Plays. They are great fun, full of wild hopes and crushed expectations. Lots of interesting things happen to stock and option prices just before and after the company makes its quarterly earnings announcement. To our way of thinking, most of the stock price changes have little to do with the fundamental measures or technical indicators, and more to do with the difference between expectations and the interpretations of what happened or will happen in the near future.

Just prior to the earnings announcement, option prices go crazy, especially the ones with the shortest time frame (for about 130 popular stocks, they are the Weekly options which will expire no more than a few days after the announcement). With the heightened degree of uncertainty brought about by the coming announcement, these options often escalate to the stratosphere. Implied volatilities (IV) might more than double from their "normal" (non-earnings-announcement) levels.

Many people are tempted to buy calendar spreads in advance of earnings because of the huge IV advantages that exist (further-out options, the ones you buy in a calendar spread, have much lower IVs than the short-term options you are selling). However, two things happen that often crush calendar spreads after the announcement. First, IVs plummet in value across the board. The stock may move higher just as you hoped but your long call might fall in value. Second, the stock might make a big move in either direction (and the further away from your calendar spread strike it moves, the less your gain or the greater your loss). It is not an easy way to make money.

We have been making PEA Play investments with options every week for several weeks, and would like to share some learning experiences with a couple of examples. First, a case study of a play that took place last Thursday and Friday -

Case Study of a PEA Play (Salesforce.com): In the week preceding the earnings announcement, several articles were published on Seeking Alpha that panned Salesforce.com (CRM).

A sample, with a quote from each:

What's The Deal With Salesforce.com?

"When viewed from the fundamentals, the current valuation of Salesforce is absurd."

Something Is Seriously Wrong With Salesforce

"… at this dilutive speed, the Salesforce.com stock is little more than a Ponzi scheme."

Salesforce Earnings Preview: 7th Consecutive GAAP Loss Expected

"What has occurred at Salesforce in recent years are efforts to maximize insider shareholder wealth with no regard to and to the exclusion of outside shareholders."

With comments like these, how could anyone expect the stock to move higher after the earnings announcement that would come out after the close on Thursday, February 28th?

Other articles mentioned the huge amount of insider selling at the company - in the last six months, over $150 million was sold by company insiders, about 8% of their holdings. It sounded like top management was bailing out before earnings were announced. (Most of the sales occurred in late December, 2012, however, and we concluded that it was largely due to efforts to avoid the capital gains tax increase that was expected to come about in 2013.)

In opposition to all this negativity about the company, we saw indications that the stock might not fall after earnings (in spite of the fact that most companies seem to trade lower after the announcement). There had not been a big run-up in the stock price leading up to the earnings announcement, whisper numbers were not higher than analysts' expectations, and most important of all, the company had almost a perfect record of ringing up higher stock prices after earnings, even when they missed expectations. For those reasons, when we made out bets (using calendar spreads), we allowed for more room on the upside than on the downside by placing more spreads at strikes higher than the current stock price.

Here are the trades we placed in one of our portfolios that we call the Earnings Eagle:

February 28, 2013 Trade Alert - Earnings Eagle Portfolio - LIMIT ORDERS

These trades will get us set up for today's earnings announcement after the close for Salesforce.com. Our break-even range extends to about 7% on the downside and 10% on the upside and we only have one day of price changes to worry about:

BTO (Buy To Open) 4 CRM Apr-13 155 puts (CRM130420P155)
STO (Sell To Open) 4 CRM Mar1-13 155 puts (CRM130301P155) for a debit limit of $2.71 (buying a calendar)

BTO 4 CRM Apr-13 160 puts (CRM130420P160)
STO 4 CRM Mar1-13 160 puts (CRM130301P160) for a debit limit of $2.99 (buying a calendar)

BTO 3 CRM Apr-13 165 puts (CRM130420P165)
STO 3 CRM Mar1-13 165 puts (CRM130301P165) for a debit limit of $3.12 (buying a calendar)

BTO 3 CRM Apr-13 175 calls (CRM130420C175)
STO 3 CRM Mar1-13 175 calls (CRM130301C175) for a debit limit of $3.10 (buying a calendar)

BTO 4 CRM Apr-13 180 calls (CRM130420C180)
STO 4 CRM Mar1-13 180 calls (CRM130301C180) for a debit limit of $2.93 (buying a calendar)

BTO 4 CRM Apr-13 185 calls (CRM130420C185)
STO 4 CRM Mar1-13 185 calls (CRM130301C185) for a debit limit of $2.48 (buying a calendar)

Note: These trades were made through Auto-Trade at thinkorswim by TD Ameritrade. There is no commission when you buy back short options for $.05 or less.

These trades were placed with CRM trading about $169. These spreads cost $6365 to place including commissions ($55). Note that the largest numbers of contracts were placed at the upper and lower extreme strike prices, and no spreads at all were at the at-the-money 170 strike. These choices resulted in a relatively flat risk profile graph curve with a little more coverage on the upside than the downside.

There was a huge implied volatility (IV) advantage to our calendar spreads. IV for the Mar1-13 weekly options was 100 compared to 36 for the Apr-13 options. The big question was how much the April options would fall in value once earnings were announced. We estimated that IV would fall by 5, (to 31) after the announcement. With this assumption, the risk profile graph looked like this:

(click to enlarge)

The graph shows that a $1500 - $2000 gain might be expected if the stock made only a minimal change in value after the earnings announcement. We set out to create positions that would result in a gain if the stock rose less than 10% or fell less than 7% after the announcement, and the graph showed that we had that coverage.

What happened, however, was that IV of the April options fell all the way to 27, reducing the amount that we were able to gain on the trades. The stock opened up about $7 higher, at about $176 and closed the day at $182. Here are the trade alerts that we issued and the prices we got for the spreads we had placed a day earlier:

March 1, 2013 Trade Alert - Earnings Eagle Portfolio - LIMIT ORDERS

With the stock higher we will take these spreads off first:

BTC (Buy To Close) 4 CRM Mar1-13 155 puts (CRM130301P155) for $.03 (no commission)

STC (Sell To Close) 4 CRM Apr-13 155 puts (CRM130420P155) for $1.70

BTC 4 CRM Mar1-13 160 puts (CRM130301P160) for $.05 (no commission)

STC 4 CRM Apr-13 160 puts (CRM130420P160) for $2.50

March 1, 2013 Trade Alert #2 - Earnings Eagle Portfolio - LIMIT ORDERS

Now we will take this one off:

BTC 3 CRM Mar1-13 165 puts (CRM130301P165) for $.05 (no commission)

STC 3 CRM Apr-13 165 puts (CRM130420P165) for a limit of $2.20

March 1, 2013 Trade Alert #3 - Earnings Eagle Portfolio - LIMIT ORDERS

BTC 3 CRM Mar1-13 175 calls (CRM130301C175)
STC 3 CRM Apr-13 175 calls (CRM130420C175) for a credit limit of $4.80 (selling a calendar)

BTC 4 CRM Mar1-13 180 calls (CRM130301C180)
STC 4 CRM Apr-13 180 calls (CRM130420C180) for a credit limit of $5.75 (selling a calendar)

BTC 4 CRM Mar1-13 185 calls (CRM130301C185)
STC 4 CRM Apr-13 185 calls (CRM130420C185) for a credit limit of $4.90 (selling a calendar)

During the day, the stock moved higher, trading as high as $183.24 ($14 higher than it was when we placed our trades on Thursday).

When we bought the calendar spreads on Thursday, February 28th, our cost was $6365. This entire amount was really not at risk because the long April options would always have a greater value than the Mar1-13 weekly options that we had sold, and we were planning on exiting all the trades on Friday, March 1 (so there would be no further decay in our long options).

We lost money on three of the six spreads we bought but the gain on the other three spreads was much greater than our losses on the losers. We collected $7985 from selling the spreads and paid $41.25 in commissions for a net receipt of $7943.75 and a gain of $1578.75 after commissions, or 24.8%. It was a day to celebrate.

Case Study #2: Dodging a Possible PEA Play Bullet: Last weekend, I wrote a Seeking Alpha article about First Solar (FSLR) which was due to announce earnings shortly -

First Solar - Long Run Major Winner That Just Might Tank Next Week. The gist of the article was that I liked the long-run prospects for the company but there were red flags on what might happen after the earnings announcement:

1. There had been a big run-up in the stock for the month leading up to the announcement.
2. Whisper numbers exceeded analysts' expectations.
3. The company had displayed large moves after past earnings announcements.
4. There was a very high percentage of shares sold short (while this may seem like a reason for the stock to move higher through a short squeeze, we have found that a high short ratio has essentially no bearing on what a stock does shortly after an announcement).

When we had seen these indicators in the past, there was almost always a drop in the stock price after the earnings. For example, last month Green Mountain Coffee Roasters (GMCR) exceeded expectations by a large margin on every measure (earnings, revenues, margins, and guidance) and the stock tanked about 7%. When expectations are high, there always seems to be some part of the announcement that disappoints, even if it is a small issue that doesn't amount to anything meaningful in the larger scheme of things.

FSLR beat earnings estimates by a large margin but fell short on revenue and guidance expectations, and the stock dropped a whopping 14%. We dodged a big bullet by not making a PEA Play investment in FSLR (even though we believe the company is undervalued at its present price). When we see heightened expectations this strong in the future, we might consider doing a back spread which makes money as long as there is a move in one direction or the other (but which loses if there is no change at all). Very rarely do we see an absolutely flat market after an earnings announcement.

Back spreads are difficult to make (at a decent price) prior to an earnings announcement because of the pervasive escalation of option prices (IV) across all the series, but they are still possible.

Other Recent PEA Play Case Studies: Over the past few weeks, we have conducted several other PEA Plays with varying (generally positive) results: More Pre-Earnings-Announcement Plays discusses Tesla Motors (TSLA) and Herbalife (HLF), Terry s Tips Subscribers Score Big Win With NTAP Earnings Play discusses Network Appliance (NTAP) and Closing Out the Buffalo Wild Wings (BWLD) Spreads.

While we prefer to make PEA Plays with options, many investors opt to buy stock and write calls against it, hoping to collect the unusually high option premium and having the stock called away at expiration. They usually sell in-the-money calls and hope the stock moves higher (where they lose their stock but keep the premium) or only a little lower (but stays above the strike price of the call they sold).

Other investors prefer to bet that the stock will trade lower after the announcement (which happens more than half the time according to our studies). They may sell the stock short and sell an in-the-money put to collect the unusually high option premium, and hope the stock ends up at a price below the strike of their short put so that they end up with no short stock and get to keep the put premium.

In any case, when trying to anticipate the direction the stock will take after an earnings announcement, it makes more sense to look at expectations than fundamental or technical indicators. In our opinion, expectations can be anticipated by checking the stock action leading up to the announcement day, by the difference between analysts' expectations and whisper numbers, and by checking the preponderance of articles (and comments made) at Seeking Alpha.

Disclosure: I am long GMCR, HLF, CRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short TSLA.