How the Options Market Predicts Risk

 

How the Options Market Predicts Risk

Risks at Earnings Season

What the Big Market Players Expect

During earnings season, I break down what I’m seeing in the options marketplace for some of the stocks most widely held by my subscribers. While the options market is by no means a definitive predictor of how a stock will move, it does present important input to help you understand the risks that the big market players see in earnings.

Below is the breakdown of the Facebook (FB) options that I released to my readers on January 28, the day of the company’s earnings announcement. You’ll note that while I didn’t make any outright prediction on the stock’s performance, I highlighted that the options market was pricing in a fairly muted move on earnings.

Facebook will report earnings this evening after the closing bell. The stock is trading higher by $0.75 today at 76.50, as the market is virtually unchanged ahead of the Federal Reserve later this afternoon. For the year, FB is lower by 1%.

Expected Move/Volatility

The options market is pricing in a move of $5.25 this week for FB, or 71.25 to the downside and 81.75 to the upside.

Volatility is elevated headed into this evening's earnings release. However, I wouldn't say it's extremely high. Below is a graph of volatility/price of FB options. The "E" represents the day of earnings. As you can see, volatility (depicted by the red line) is lower in comparison to the previous earnings releases, which could signify less expected movement. (Charts courtesy of LiveVol.)

Compared to the expected $5.25 move this week, in the past four quarters of earnings, FB stock has moved:

October 2014 earnings: 80.75 to 75.75 July 2014 earnings: 71.25 to 75 April 2014 earnings: 61 to 58 January 2014 earnings: 53.50 to 61

Of the earnings listed above, the largest upside move was $7.50, and the largest downward move was $5.00.

Please note, volatility is elevated, and buyers of calls/puts will see a dramatic loss of value in these options if the stock doesn't make a large move in the trader's preferred direction.

Skew

As I've written about in the past, skew is the perceived risk of an extreme upside or downside move in the stock. In general, puts are bid higher than calls as most traders are long stock, so they buy puts and sell calls to protect their stock positions.

Here is a look at the skew graph of Facebook:

The red line in this graph is the skew for options that expire this week.

The blue line is the skew for options that expire on February expiration.

The left side of the X axis are out-of-the-money puts, and the right side of the X axis are out-of-the-money calls.

This FB skew graph is saying there is minimal extreme downside risk being priced in the options market, which is rare for an earnings stock. Similarly, there is very little upside extreme risk. This is not terribly surprising, having seen the relatively lower volatility compared to past earnings as mentioned above.

Order Flow

Order flow in a popular stock like Facebook is very hard to read. However, there's no question that in general there is much more call buying in FB than put buying. For example, as of noon Eastern today, 100,000 calls have traded, compared to 52,000 puts, or a ratio of 1.9:1.

Open Interest

Open interest in Facebook options is skewed heavily bullish as it appears many traders are betting on further upside for FB in the days/months to come. In fact, there's hardly any open interest in the puts worth mentioning. Here are a couple of options that are heavily owned based on open interest figures:

30,000 February 80 Calls

25,000 February 85 Calls

20,000 June 80 Calls

48,000 January 80 Calls (exp. 2016)

Conclusion

Volatility and skew are telling me that the big market players are expecting a relatively muted move today for FB. And the continued bullish option activity would cause me to lean more bullish than bearish. That said, in this environment, a company needs to soundly beat expectations (much like AAPL) in order to get a significant upside move.

Look Back

So how did Facebook fare on earnings? Initially the stock popped higher by a couple of dollars, before selling off in the days following along with the overall market. The stock is now within a couple of percent of its price before earnings, and the movement was extremely muted.

While there are a couple of instances every earnings season in which the options market “got it wrong,” in the case of Facebook—and most stocks, the options market does a great job predicting the risks associated with earnings.

If you would like to learn more about options and how options trading can help you become a better investor, take a look at Cabot Options Trader. Click here to find out more about options and how you can try our advisory risk free for 60 days.

Your guide to options trading,

Jacob Mintz,
Chief Analyst of Cabot Options Trader and Cabot Options Trader Pro


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