Earnings
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# Evaluating Earnings Variability

Richard Croft
May 3, 2016
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We often hear about the expected movement in a stocks’ share price based on an upcoming earnings release. Calculated as an implied trading range by reverse engineering the option pricing formula.

Traders typically use some version of the Black Scholes option pricing model to calculate the theoretical fair value for a call and a put on the underlying stock. Inputs such as time to expiry, current stock price, strike price, risk free rate of return, expected dividends payable by the underlying stock and of course, volatility. The latter input being the variable – i.e. best guess – within the pricing model.

Reverse engineering involves plugging the option price into the formula and asking it to solve for volatility. This output is the option’s implied volatility which is to say, what volatility input is required to generate the current price for the option. When analysts tell us that an upcoming earnings release could move a stocks’ price up or down by 10% they are basing that comment on the implied volatility calculation.

An easier way to arrive at the similar analysis without having P.H.D. in mathematics is to look at the current price of the near term at-the-money straddle on the underlying stock. A straddle involves the simultaneous purchase or sale of a call and put at the same strike price with the same expiration date.

A straddle buyer wants the underlying stock to move far enough to cover the cost of both options. The seller of a straddle wants the underlying stock to trade within a range bounded by the total premium of the call and the put. With either approach the trader is making a bet as to expected volatility prior to the options expiry. Neither is a directional bet on where the underlying stock is expected to trade.

To bring some perspective to this discussion let’s look at the expected price range for a stock where there is an impending earnings release. For example, BCE Inc. is reporting earnings next week. The consensus estimate for quarterly earnings is 85 cents per share.

BCE Inc. is a large blue chip company with a long history of paying and more importantly, increasing quarterly dividends. As such the earnings estimates provided by analysts tend to be clustered in a tight range. Very different from say, a company like Teck Resources that is also reporting next week.

To calculate the projected price range for BCE Inc. based on the upcoming earnings number we would look at the near term (i.e. May expiration) at-the-money straddle. BCE closed Friday at \$58.48, so the closest at-the-money strike is \$58.00. Based on Fridays numbers the BCE May 58 call was trading at \$1.05 with the BCE May 58 put at \$0.55. The total value of both options is \$1.60 per share.

The next step is to add the total cost of the straddle to the strike price so that we have an upside target of \$59.60. If we subtract the \$1.60 from the strike price we end up with a downside number at \$56.40. That is the expected trading range of BCE between now and the May expiration which in percentage terms, is a range of 2.736%. Quite low based on the expected earnings number.

Applying the same math to Teck Resources (TMX: TCK.B) where there is a rather large spread in the expected earnings data we get a much different picture. TCK.B closed Friday at \$13.17 per share which makes the May 13 strike the best match to come up with a possible trading range.

The TCK.B May 13 call was trading at \$1.40 with the TCK.B May 13 put at \$1.25. Total cost for the two options is \$2.65 which gives us a trading range of \$10.35 and \$15.65. In percentage terms that is a 21.121% trading range between now and the third Friday in May.

As we are well into first quarter earnings season option traders can play this variability where the payoff will depend on whether the company matches, beats or misses their EPS expectation.

Strategically companies do their best to guide analysts’ to a reasonable expectation. The objective is to guide estimates to the lower end of a range so that management can beat expectations. Easier for management to take a congratulatory lap rather than trying to explain a failed quarter.

Of course many factors are beyond the control of management. The sharp decline in oil prices being a recent case in point. The variability of gold prices and commodities in general being another factor.

On the other hand, companies like Thompson Reuters and BCE Inc. have relatively stable earnings streams allowing managements to provide guidance that is more often than not within basis points of the end number.

The options market is very good as calculating just how variable quarterly earnings might be. This can be useful information for investors looking to implement a new position, hedge risk into an earnings release, or to speculate on whether the company is likely to hit or miss on guidance.

With that in mind here is a list of companies who will release earnings this week. I have included the consensus earnings number as well as the implied trading range based on May at the money options.

Stock Price Range Percent At-The-Money
Symbol Price Up Down Range Calls Puts Strike Est.
TCK.B \$13.17 \$15.65 \$10.35 20.121% 1.40 1.25 13.00 -0.09
PD \$6.00 \$6.78 \$5.22 13.000% 0.40 0.38 6.00 -0.15
AEM \$52.39 \$57.10 \$46.90 9.735% 2.75 2.35 52.00 -0.03
ABX \$20.41 \$21.68 \$18.32 8.231% 1.05 0.63 20.00 0.09
HSE \$18.05 \$19.45 \$16.55 8.033% 0.75 0.70 18.00 -0.23
G \$21.65 \$23.66 \$20.34 7.667% 0.66 1.00 22.00 0.03
CVE \$19.24 \$20.43 \$17.57 7.432% 0.83 0.60 19.00 -0.38
POT \$22.72 \$24.66 \$21.34 7.306% 0.70 0.96 23.00 0.23
SU \$36.30 \$38.03 \$33.97 5.592% 1.18 0.85 36.00 -0.22
SJ \$46.56 \$48.25 \$43.75 4.832% 1.45 0.80 46.00 0.51
CU \$35.05 \$37.65 \$34.35 4.708% 0.20 1.45 36.00 0.62
TRI \$51.70 \$54.30 \$49.70 4.449% 0.85 1.45 52.00 0.60
CNR \$83.45 \$87.30 \$80.70 3.954% 1.40 1.90 84.00 0.93
BCE \$58.48 \$59.60 \$56.40 2.736% 1.05 0.55 58.00 0.85

Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group