The famous physicist Niels Bohr once said that "prediction is very difficult, especially about the future." While true for many aspects of quantum mechanics, traders and investors have several tools to help make accurate predictions in the financial markets. Oftentimes, these tools are derivative financial instruments that can help provide an aggregate picture of future market sentiment - tools like options.
TUTORIAL: Options Basics

Such predictions can be particularly useful for active traders during earnings season when stock prices are most volatile. During these times, many traders and investors use options to either place bullish bets that lever their positions or hedge their existing positions against potential downside. In this article, we'll look at a simple three-step process for making effective earnings predictions using options.

Step 1: Analyze the Chain for Opportunities
The first step in analyzing options to make earnings predictions is to identify unusual activity and validate it using open interest and average volume data. The goal in this step is to find some specific options that may be telling for the future and create an initial list of targets for further analysis.

Finding these target options is a two-step process:

1. Look for the Unusual - Look for call or put options with current volume that is in excess of the average daily trading volume, particularly in near-term months.

2. Compare Open Interest - Make sure that the current volume exceeds the prior day's open interest, which indicates that today's activity represents new positions.

In Practice: Baidu
If we visit the Yahoo! Finance options analysis page for Baidu ADR (Nasdaq:BIDU), we may find an options chain like this:

Baidu options analysis
Figure 1: An options analysis page for Baidu (BIDU).
Source: Created with Yahoo! Finance Options Tool

Notice that the highlighted near-month call options are trading with volumes significantly higher than their open interest, which suggests that the options are being accumulated by traders and/or investors. We could also look at the current day's volume and compare it to the average daily volume to draw similar conclusions, but open interest is generally considered to be the most important to watch.
Step 2: Determine the Magnitude with Straddles
The second step in analyzing options to make earnings predictions is to determine the magnitude of the anticipated move. Since most options appreciate in value when volatility increases, implied volatility can tell us when the market is anticipating a big move to the upside or downside. Luckily, straddles are designed to take advantage of implied volatility, so we can use them to calculate an exact magnitude. (To learn more about volatility, see Option Volatility: Why Is It Important?)

Straddles represent an options strategy that involves purchasing call and put options with the same strike price and expiration date. By purchasing an at-the-money straddle, options traders are positioning themselves to profit from an increase in implied volatility. Therefore, looking at the price of the at-the-money straddle can tell us the magnitude of this implied volatility.

In Practice: Google
If we purchase one at-the-money Google (Nasdaq:GOOG) call option for $1,200 per contract and one at-the-money GOOG put option for $1,670 per contract, then the cost of the at-the-money straddle will be $2,860 plus any commissions paid. With GOOG's underlying shares trading at $575.50 per share, this means that we can expect a move of approximately 5% or $2,860 / ($575.50 x 100).

The at-the-money straddle for GOOG will then look something like this:

An at-the-money straddle for Google
Figure 2: An at-the-money straddle for Google.
Source: Created with OptionsOracle by Samoa Sky

Step 3: Decide on Hedging or Leveraging
The third and last step in analyzing options to make earnings predictions is to determine the direction of the move. While we only really have access to trading volume, we can use the bid and ask prices and trading data to make fairly accurate assumptions. Simply put, trades hitting the bid price are likely selling transactions, while those hitting the ask price are likely buying transactions. (For background on the bid-ask, see The Basics Of The Bid-Ask Spread.)

Traders and investors can also look at the option chain for various types of options strategies that are most likely to occur around earnings season. For example, similar volumes in put and call options in the same price and expiration dates may signal a straddle bet on volatility, while call options being sold could indicate long-term investors hedging their positions by selling calls – a bearish indicator.

TUTORIAL: Option Greeks

Traders and investors can find this information by looking at real-time trades through their brokerage platforms or by using one of many websites that provide real-time trading information - or by simply using delayed data from websites like Investopedia or Yahoo! Finance.

Bottom Line
While using options data to predict earnings moves may be part art and part science, many financial experts find it invaluable when predicting not only earnings moves, but also mergers and acquisitions and other anticipated price movements. Using this simple three-step process, you can make your own earnings predictions using options data:

1. Identify unusual options trades and validate them by comparing the current day's volume to the open interest and/or daily trading volume.

2. Determine the magnitude of the move higher by calculating the cost of an at-the-money straddle, which provides an idea of anticipated volatility.

3. Discover the direction of the trade by looking at the bid and ask prices, as well as analyzing the overall option chain to look for the potential types of trades being placed.

As you put this technique to use, you'll find that the future becomes much easier to predict. (For additional reading, also take a look at Option Strategies For A Down Market and Profit On Any Price Change With Long Straddles.)

Related Articles
  1. Active Trading Fundamentals

    4 Stocks With Bullish Head and Shoulders Patterns for 2016 (PG, ETR)

    Discover analyses of the top four stocks with bullish head and shoulders patterns forming in 2016, and learn the prices at which they should be considered.
  2. Chart Advisor

    Uptrending Stocks Dwindle, a Few Remain (EW, WEC, WR)

    The number of uptrending stocks is shrinking, but here a few that remain in uptrends.
  3. Chart Advisor

    Trade Setups Based on Descending Trend Channels (LBTYK, RRC)

    These descending trend channels have provided reliable sell signals in the past, and are giving the signal again.
  4. Chart Advisor

    How Are You Trading The Breakdown In Growth Stocks? (VOOG, IWF)

    Based on the charts of these two ETFs, bearish traders will start turning their attention to growth stocks.
  5. Retirement

    Roth IRAs Tutorial

    This comprehensive guide goes through what a Roth IRA is and how to set one up, contribute to it and withdraw from it.
  6. Chart Advisor

    Breakout Opportunity Stocks: CPA, GNRC, WWE

    After a period of contracting volatility, watch for breakouts and bigger moves to come in these stocks.
  7. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  8. Charts & Patterns

    How To Use Volume To Improve Your Trading

    The basic guidelines to analyzing volume may not apply in all situations, but overall, they can help direct entry and exit decisions.
  9. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  10. Trading Strategies

    4 Common Active Trading Strategies

    Active trading entails buying and selling securities with the intent of profiting from short-term price movements.
RELATED FAQS
  1. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  2. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  3. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  4. Do hedge funds invest in commodities?

    There are several hedge funds that invest in commodities. Many hedge funds have broad macroeconomic strategies and invest ... Read Full Answer >>
  5. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  6. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
Hot Definitions
  1. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  2. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  3. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  4. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
  5. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
Trading Center