Optimistic traders have bid up the share prices for Cisco Systems, Inc. (CSCO) ahead of its quarterly earnings announcement. There's no way to accurately predict the direction a stock will move after an earnings announcement. However, a comparison of the price action between stock prices and option prices shows that, if Cisco shares fall, creating a reversion back to its 20-day moving average in the first few days after the announcement, downside-focused traders are in a position to capture the best profits.
- Traders and investors have driven the price of Cisco shares higher heading into the announcement.
- Cisco's stock price has been closing well above its 20-day moving average.
- Put options are priced for a smaller drop and call options for a larger gain.
- The volatility-based support and resistance levels are positioned better for a move lower.
- This setup creates a greater opportunity for traders to profit if the price falls.
Option trading represents the activities of investors who want to protect their positions or speculators who want to profit from correctly forecasting unexpected moves in an underlying stock or index. That means option trading is literally a bet on market probabilities. By comparing the details of both stock and option price behavior, chart watchers can gain valuable insight, although it helps to understand the context in which this price behavior took place. The chart below depicts the price action for Cisco's shares and the setup leading into the earnings report.
The one-month trend of the stock has the shares moving strongly higher, as Cisco climbed from below $45 per share to over $48 in the past few days as the announcement day draws near. The price climbed from the middle region of trading prices to the upper extreme depicted by the technical studies on this chart. The studies are formed with 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 moved from the middle range to the upper extreme. This is an optimistic price move for Cisco shares.
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 one to two weeks of trading on a daily chart.
In this context where the price trend for Cisco made a strong move higher during the previous month, chart watchers can recognize that traders and investors are expressing optimism going into earnings. That makes it important for chart watcher to determine whether the move is presaging investors' expectations for a favorable earnings report. One point of evidence to support the idea that investors are expecting good news from the company report can be found in the comparison of the volatility range depicted on the chart by the purple lines and the purple box in the background. Prices have moved so optimistically that they are near the high of this range.
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.
Option traders recognize that Cisco shares are pushing higher and have priced their options as a bet that the stock will close within one of the two boxes depicted in the chart between today and Feb. 12, the Friday after the earnings report is released. The green-framed box represents the pricing that the call option sellers are offering. It implies a 72% chance that CSCO shares will close inside this range by the end of the week, if prices go higher. The red box represents the pricing for put options with the same probability if prices go lower on the announcement.
It is important to note that trading on Friday featured 124,666 call options traded compared to 48,691 put options traded. This demonstrates the bias that option buyers have. The 2.5:1 call-to-put ratio implies that option traders are expecting strongly positive news and giving a bias toward a move higher, as shown in the chart below.
The purple lines on the chart are generated by a 10-day Keltner Channel study set at four 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. It is notable in this chart that the call option pricing exceeds the upper line of this study, suggesting that buyers could run into eager sellers above this line, potentially causing the price action to reverse.
These support and resistance levels show less support for prices if they should begin to fall and more resistance for prices if they begin to rise. As a result, and because of the obvious bias that option buyers have toward good news, it is possible that bad news will catch investors by surprise and could generate an unexpectedly strong move. The rapid move higher in prices may be driven by analysts who have discovered good reasons to expect a favorable report. After the previous earnings announcement, Cisco shares rose roughly 10% in the days following. A much bigger downside move could be the result if investors' expectations are disappointed.
While Cisco is not typically thought of as a bellwether stock, its high profile makes it influential in the markets. Therefore, it may be that any negative news from the company could worry investors and create a ripple effect through the markets. This could, in turn, have a recognizable impact on broad market exchange traded funds (ETFs) such as Invesco's Nasdaq 100 Index ETF (QQQ).
The Bottom Line
Cisco option traders heavily bought call options before the earnings announcement, expecting very good news from the company. If that news does not materialize, Cisco shares could drop substantially. Right now, the put options for Cisco are not pricing in a wide range, so traders are dismissing the possibility of a large price drop to some degree. The volatility price range shows little upside for calls, making the trade more difficult for call buyers to be profitable than put buyers in the event of a comparably large move either way.