After Best Buy Co., Inc. (BBY) reported that it had beaten analysts' expectations for its fiscal second quarter earnings results, option traders are taking actions suggesting that they think the share price will move higher in the future. This may come as no surprise, considering the share price rose 8.3% the day after the announcement. Best Buy reported earnings per share (EPS) of $2.98 and revenue of $11.85 billion, exceeding forecasts calling for EPS of $1.85 EPS and revenue of $11.49 billion. Prior to the announcement, investors had bid down BBY's share price to a below average range.
Traders and investors had bid down the share price of BBY before earnings; however, option trading activity after earnings indicate that traders' confidence in BBY's share price going forward has grown. That's because the price action has risen to an above average range, while option activity and the open interest implies that traders are buying call options and selling puts.
- Traders and investors bought shares of Best Buy following the earnings announcement, as the stock rose 8.3%.
- The share price of BBY closed well above its 20-day moving average.
- Put and call option activity appears to be positioned for the share price to continue to rise.
- The volatility-based support and resistance levels allow for a stronger move to the downside.
- This setup creates an opportunity for traders to profit from a reversal in the earnings-based price increase.
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 BBY's share price as of Aug. 24, illustrating the setup after the earnings report.
The one-month trend of the stock saw the share price falling below the 20-day moving average in the week before earnings, before rising well above it after the announcement, closing in the top third 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 risen to the upper third of the volatility range. This price move from BBY shares implies that investors are growing confident in the share price of BBY going forward.
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 BBY 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 BBY shares would move downwards after earnings.
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.
The recent activity of options traders implies that they consider BBY shares undervalued and have bought call options as a bet that the stock will close within the box depicted in the chart between today and Sept. 17, the next monthly expiration date for options. The green-framed box represents the pricing that the call option sellers are offering. It implies a 70% chance that BBY shares will close inside this range or higher by Sept. 17. So sellers are only mildly bullish. However, buyers are snapping up this pricing, suggesting that buyers consider these options underpriced. Since the pricing implies only a 30% chance that prices could close above this green box, it appears that buyers are willing to take those long odds.
It is important to note that open interest on Tuesday featured over 89,000 call options compared to over 101,000 puts, demonstrating the bias that option buyers had. This normally implies that option traders expect downward price movement. After earnings, volatility has decreased dramatically, but the number of put options in the open interest increased. This signals a bearish sentiment.
For strikes at the money and one step either direction, the call volume outweighs the put volume. Out-of-the-money put volume declines at a much slower rate than out-of-the-money call volume. However, it should be noted that the implied volatility of this put option volume is declining, indicating that put options, while still being traded in large volumes, are being sold more than purchased.
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 downwards. This suggests that option buyers have a stronger conviction of the price moving higher in the weeks following the report. Although investors and option traders expected negative movement from the report, the share price moved further to the upside than it did after the last earnings report.
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, BBY shares fell 1.6% in the day following and continued to fall the following week. Investors may be expecting a different kind of move in price in the week after this announcement. 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 downside.
Best Buy beat analysts' expectations for revenue and earnings per share. The share price rose 8.3% the day after the announcement, moving to the top third of the volatility range, closing well above its 20-day moving average. Option traders appear to be buying calls and selling puts, which translates into a bullish outlook. This activity, however, does provide more room in the volatility range for a downward move in the share price in the future.
Option Trading Example
As a bet on market probabilities, unusual option activity can offer traders insight into investor sentiment toward the company and illustrate what "smart money" is doing with large volume orders. One way to capture the bullish sentiment reflected in the post-earnings activity of BBY would be to open a calendar spread.
A calendar spread, also known as a horizontal spread, is an option strategy that involves simultaneously buying and selling two of the same type of options with different expiration dates but the same strike prices. Calendar spreads allow traders to construct a trade that minimizes the effects of time. A calendar spread is most profitable when the underlying asset does not make any significant moves in either direction until after the near-term option expires.
For example, to capture BBY's bullish sentiment, selling the Sept. 17 $125 call will deliver a credit of $2.18 and has a breakeven price of $127.18. Buying the Dec. 17 $125 call costs $7.00 and has a breakeven price of $132. After selling the Sept. 17 call and buying the Dec. 17 call, the net cost for this trade is $4.82, or $482 per contract (data snapshot as of 3:59 EDT, 8/24/2021). The idea behind this trade is to capture the short-term upward trend. The chart below illustrates the setup for this example.
No strategy is without risk. The maximum risk on this trade is the amount paid to open the positions, or $4.82 per contract. Calculating the maximum profit on a calendar spread at the outset is difficult, as the maximum profit is equal to the time value left in the bought option at the sold option expiration, minus the net debit (or cost of the trade). However, professional traders target a profit of 15% to 30%.