After Eli Lilly and Company (LLY) reported that it missed analysts' predictions for its fiscal second quarter earnings results, option traders are taking actions that indicate they think the share price will move higher in the future. This may come as no surprise considering that the share price rose 2.5% the day after the announcement.

Eli Lilly reported earnings per share (EPS) of $1.87 and revenue of $6.74 billion, missing analysts' expectations calling for EPS of $1.89 while beating expectations for revenue of $6.59 billion. Prior to the announcement, investors had bid up the share price of LLY to an extreme range, with a large number of sold put options in the open interest.

Option trading volumes indicate that traders had been buying calls and selling puts; however, option trading activity after earnings indicates that traders are still confident in LLY's share price going forward. That's because the price action has remained in an extreme range, while option activity implies that traders continue to buy calls and sell puts.

Key Takeaways

  • Traders and investors bought shares of LLY following the earnings announcement, as the stock rose 2.5%.
  • The share price of LLY continued to close above its 20-day moving average.
  • Put and call option activity appears to be positioned for the share price 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 movement.

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 LLY's share price as of Aug. 9, illustrating the setup after the earnings report.

Earnings results for Eli Lilly and Company (LLY)

Current Trends

The one-month trend of the stock saw the share price pushing above the upper extremes of the volatility range, closing well above the 20-day moving average, closing in the highest extremes of the 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 exceeded the upper bounds of the volatility range. This price move from LLY shares implies that investors are extremely confident in the share price of LLY 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 optimism going into earnings, based on the price trend for LLY closing at the upper extremes of the volatility range. 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 LLY shares would move upwards 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 options traders implies that they consider LLY 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 Aug. 20, 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 LLY shares will close inside this range or higher by Aug. 20. 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 Aug. 9 featured over 65,000 call options compared to over 90,000 puts, demonstrating the bias that option buyers had, as 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.

Option pricing for Eli Lilly and Company (LLY)

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. 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 positive movement from the report, the share price moved further to the upside than it did after the last earnings report.

Volatility pattern for Eli Lilly and Company (LLY)

These support and resistance levels show a large range of support and resistance for prices. As a result, it is possible that there could be a large move in either direction in the near future. After the previous earnings announcement, LLY shares fell less than 1% in the day following before rising the following week. Investors may be expecting the same 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.

Wrapping Up

LLY beat expectations for revenue but missed analysts' predictions for EPS. The share price rose 2.5% the day after the announcement and has remained at the upper extreme of the volatility range, closing well above the 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 LLY would be to open a debit call spread.

A debit call spread, a type of vertical spread, is an option strategy that involves simultaneously buying and selling two call options with the same expiration date but different strike prices. Although there is an initial cost on the transaction, this strategy is based on the belief that the stock will rise in price, making the purchased call option more valuable in the future. The best-case scenario would be for LLY's share price to rise to or above the strike of the option sold. This would deliver the maximum amount of profit while limiting risk. 

For example, to capture the bullish sentiment, buying the Sept. 10 $260 call costs $12.40 and has a breakeven price of $272.40. Selling the Sept. 10 $275 call will deliver a credit of $4.40, with a breakeven price of $279.40. After buying the $260 and selling the $275 call, the net debit for this trade is $8.00, or $800 per contract. The breakeven price of the trade at expiration is $268 (data snapshot as of 3:59 EDT, 8/9/2021). The chart below illustrates the setup for this particular debit call spread.

Eli Lilly and Company (LLY) example

No strategy is without risk. That maximum risk on this trade is the total debit paid for the trade, or $800 per contract. Because this strategy sells a call option with a higher strike than the one purchased, the potential profit is capped, as opposed to simply buying a call option by itself. For this particular example, the maximum potential gain is $700. The potential return on risk for this trade can be calculated as $700 / $800 = 87.5%.