After American Eagle Outfitters, Inc. (AEO) reported that it had missed analysts' revenue expectations for its fiscal second quarter earnings report, option traders are taking actions suggesting that they think the share price will continue to move lower in the future. This may come as no surprise, considering the share price fell more than 10% the day after the announcement.

American Eagle Outfitters reported earnings per share (EPS) of $0.60 and $1.19 billion in revenue—analysts had been expecting $0.55 in EPS and $1.22 billion in revenue. In addition, the apparel company's e-commerce business decelerated compared with the prior year, dropping 5%. Prior to the announcement, investors had bid down AEO's share price below its 20-day moving average.

Traders and investors slightly bid down the share price of AEO before earnings; however, option trading activity after earnings indicate that investor confidence in AEO's share price going forward is fading. That's because the price action has fallen to an extreme range, while option activity and the open interest imply that traders are selling call options and buying puts.

Key Takeaways

  • Traders and investors sold off shares of American Eagle Outfitters following the earnings report as the stock fell more than 10%.
  • The share price of AEO closed well below its 20-day moving average. 
  • Put and call option activity appears to be positioned for the share price to continue to fall.
  • The volatility-based support and resistance levels allow for a stronger move to the upside.
  • This setup creates an opportunity for traders to profit from a reversal in the earnings-based share price decline.

Option trading is a literal bet on the probabilities of the market—a bet made by traders that are, on average, better informed than most investors. The key to maximizing insight into option trading is to understand the context in which the price movement took place. The chart below illustrates the price action for AEO's share price as of Sept. 10, illustrating the setup after the earnings report. The price is compared to State Street's Retail Sector ETF (XRT).

Earnings pricing for American Eagle Outfitters (AEO)

Current Trends

The one-month trend of AEO stock saw the share price briefly rising above the 20-day moving average twice, only to fall lower each time. It's notable that AEO's performance had been relatively in line with XRT until mid-July, when the share price began a downward trend. The price closed in the lower extreme of the volatility range depicted by the technical studies on this chart.

These studies are formed by 20-day Keltner Channel indicators. These depict price levels that represent a multiple of the Average True Range (ATR) for the stock. This array helps to highlight the way the price has fallen to the lower extremes of the volatility range. This price move from AEO shares implies that investors are losing confidence in the share price of AEO going forward.

Tip

The Average True Range (ATR) has become a standard tool for depicting historical volatility over time. The typical average length of time used in its calculation is 10 to 20 time periods, which includes two to four weeks of trading on a daily chart.

Chart watchers can recognize that traders were expressing pessimism going into earnings, based on the price trend for AEO closing below the 20-day moving average. Chart watchers can also form an opinion of investor expectations by paying attention to option trading details. Prior to the announcement, traders appeared to be expecting that AEO shares would move downwards after earnings.

Tip

The Keltner Channel indicator displays a set of semi-parallel lines based on a 20-day simple moving average and an upper and lower line. Because the upper lines are drawn by adding a multiple of ATR to the average and the lower lines are drawn by subtracting a multiple of ATR from the average price, then this channel indicator makes for an excellent visualization tool when charting historical volatility.

Trading Activity

The recent activity of option traders implies that they consider AEO shares overvalued, even at the lower end of the volatility range. As a result, traders have been selling calls and buying puts. Over the past five days, put option open interest has increased 8.9%, while call option open interest has risen 0.7% in the same span. It is important to note that open interest on Friday featured over 107,000 call options compared to over 84,000 puts. Friday's option volumes also featured nearly 24,000 calls compared to almost 4,000 puts.

Normally, this nearly 6-to-1 ratio favoring call options would reflect a bullish sentiment. However, the implied volatility for these options has been falling, indicating that these options are being sold more than they are being purchased. While the raw numbers have call options in the lead, this is, historically by percent, some of the highest open interest for put options that AEO has had in over the past year. This indicates an overall bearish sentiment toward the AEO share price.

American Eagle Outfitters (AEO) Open Interest Rank

marketchameleon.com

These gauges represent the relative level of open interest over the past 52 weeks. The higher these gauges read, the more expensive options on AEO are currently priced compared to the past year. The gauge reading currently shows that AEO options are relatively expensive, suggesting that option sellers have a pricing advantage right now.

The purple lines on the chart are generated by a 10-day Keltner Channel study set at 4 times the ATR. This measure tends to create highly correlated regions of strong support and resistance in the price action. These regions show up when the channel lines make a noticeable turn within the previous three months.

The levels that the turns mark are annotated in the chart below. What is notable in this chart is that the call and put pricing are in such disparity with plenty of space to run upwards. This suggests that option buyers have a stronger conviction of the price moving lower in the weeks ahead.

Volatility pattern for AEO

These support and resistance levels show a large range of support and resistance for prices. As a result, it is possible that there can be a large move in either direction in the near future. After the previous earnings announcement, AEO shares rose 5.7% in the day following the announcement before falling the next week. With lots of room in the volatility range, share prices could rise or fall more than expected in the near term; however, there is more room in the volatility range to support a move to the upside.

Wrapping Up

While AEO beat analyst expectations for EPS, the company missed on revenue forecasts. The company's e-commerce business dropped 5%. As a result, investors sold off AEO, and the share price dropped more than 10%, moving to the lowest extremes of the volatility range. The share price closed well below AEO's 20-day moving average. Option traders appear to be selling calls and buying puts, which translates into a bearish outlook. This activity, however, does provide more room in the volatility range for an upward move in the share price in the future.