Nvidia Is Vulnerable To A Sell-Off After Its Earnings Announcement

| About: NVIDIA Corporation (NVDA)


The large cap chip maker, NVIDIA, is due to report its Q4 earnings after the close on February 9th.

After last quarter's overwhelmingly impressive results, the stock has climbed nearly 70%.

By a number of measures, sentiment appears extremely bullish for NVIDIA. This extreme bullishness could result in disappointment if NVIDIA fails to deliver yet another fantastic earnings report.

The large cap chipmaker, NVIDIA (NASDAQ:NVDA), was the darling of 2016, with the stock gaining over 225% over the course of the year. Each of its earnings announcements have been associated with a positive reaction from investors, with the most recent announcement, which was extremely positive by all measures, initiating a price surge which would take NVDA from $67 to $117 in three short months. Their Q4 2016 earnings report is scheduled to be released February 9th after the close. Investors appear optimistic, with investors bidding up the stock over the last three weeks, likely trying to get into NVDA before its next announcement. But, are investors too optimistic? Moreover, will this overoptimism lead to a potentially significant selloff after their earnings announcement? Read below.

Market Expectations

When it comes to strong performance in a stock in the days and weeks following its earnings announcement, it is because the earnings announcement exceeded the vast majority of investors' expectations. If investors are overly optimistic about an earnings announcement, it can set the bar high, and sometimes impossibly high, for the company's results to exceed those expectations. That means that even if earnings beat the consensus estimates, the stock price could still fall because earnings did not "beat estimates enough" and overly optimistic investors were disappointed.

Two indicators come to mind for gauging what investors are expecting out of a stock: surveys and open interest trends in call/put options. Surveys, the first gauge, and survey websites like PredictWallStreet.com can help investors find investor sentiment on any stock or ETF. As it stands right now, 85% of survey respondents expect NVDA to be higher than it is today in a week, 88% expect it to be higher one month from now, and 87% expect it to be higher in three months. Let's compare this to responses for the SPDR S&P 500 ETF (NYSEARCA:SPY). In one week, 50% of respondents expect it SPY, and thus the S&P 500, to be higher than it is today. 44% expect SPY to be higher one month from now, and 68% expect it to be higher in three months.

Investor Sentiment/Expectations - NVDA Vs, SPY
Percent Bulls - Timeframes NVDA SPY Difference
One Week 85% 50% +35% NVDA
One Month 88% 44% +44% NVDA
Three Months 87% 68% +19% NVDA

So the surveys suggest that investor sentiment expectations for NVDA are very high and bullish, and with such high expectations, the door for disappointment is likely wide open.

Let's look at the other metric to confirm this, open interest trends in the option market.

Open Interest Trends

While surveys are good for gauging what investors are thinking, it is much more useful from a portfolio management standpoint to know what investors are doing. The option market gives us insights on how investors are betting ahead of earnings. Additionally, the option market, unlike the stock market, exposes the extremes in investor sentiment, as options, and especially out of the money options, are very leveraged.

So, let's see how investors are betting on this upcoming earnings announcement and compare it to NVDA's past eight quarterly earnings announcements. I'll use the call open interest for the first five out-of-the money strike prices on the next-to-expire non-weekly option contract, as out of the money options tend to attract the most high conviction, speculative investors (due to their leverage). Then, I'll compare it to the put open interest for the first five out of the money strike prices for the same expiration. The ratio of the two will tell how investors are betting ahead of earnings.

See below for the option statistics for NVDA's past four earnings announcements. The higher the ratio, the more investors are betting on a positive earnings surprise than they are a negative surprise. A ratio below one means more investors are betting on a negative surprise than a positive surprise.

Using Option Open Interest To Gauge Sentiment
Earnings Date Call Open Interest Put Open Interest Ratio
2/9/2017 7981 1439 5.55
11/10/2016 8093 1082 7.48
8/11/2016 5962 3800 1.57
5/12/2016 6837 7984 0.86
2/16/2016 23876 16963 1.41
11/5/2015 8477 12149 0.70
8/6/2015 25565 9539 2.68
5/7/2015 6557 8070 0.81
2/11/2015 9347 9731 0.96

As we can see in the table above, for every put contract open, there are currently 5.55 call contracts open. This is the second highest open interest ratio in two years, and confirms that investors are extremely optimistic about NVDA's earnings.

Putting It All Together

All suggest investors are overly optimistic about NVDA's earnings announcement, which opens the door for disappointment. That's not to say that the NVDA is going to definitely weaken significantly following its earnings announcement, but it does say that expectations have been set very high. These expectations will likely have to be exceeded for NVDA to continue to climb, which probably means a significant beat above Wall Street Consensus estimates of $0.84 Q4 EPS and revenue of $2.106 billion. This can happen, as it did when the Q3 earnings report was released, but both EPS and revenue came in at least 20% above the Wall Street Consensus. Can this happen again? Based on historical probabilities, perhaps (but unlikely). But either way, given investors' overly optimistic expectations, NVDA appears very vulnerable to a selloff.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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Tagged: , Semiconductor - Specialized, Earnings
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