After International Business Machines Corporation (IBM) reported that it had beaten estimates for its second quarter earnings results, option traders are taking actions that imply they think the share price will drift higher in the future. This may come as a surprise considering that the IBM share price rose less than 1% the day the report was announced. Prior to the announcement, investors had bid down the share prices, with a sizable amount of put options in the open interest.
Option trading volumes indicated that traders had been buying puts and selling calls; however, options activity after earnings suggests that traders are optimistic that IBM could begin to trend upwards going forward. That's because the price action has broken resistance, while option activity implies that traders are both selling puts and buying calls.
A comparison of the price action between stock prices and option trading activity on the days following earnings shows some evidence to suggest that option traders might be cautiously optimistic. IBM's share price fell less than 1% the day of earnings, before rising in after-hours trading and closing below its 20-day moving average the day after the announcement. Additionally, put and call option activity both increased. This could happen because options traders believe that IBM will find support at these elevated levels and will not decline in the near term.
- Traders and investors bought shares in IBM following the earnings announcement as the stock gained 1.5%.
- The share price of IBM rose closer to its 20-day moving average, reversing the downward trend started prior to the earnings announcement.
- Put and call option activity appears to be positioned for the price to continue to rise.
- The volatility-based support and resistance levels allow for a stronger move downward than upward.
- This setup creates an opportunity for traders to profit from a continuation in the earnings-based share price increase.
Because option trading represents the activities of investors who want to hedge their long positions or speculators who want to profit from correctly predicting unforeseen movement in an underlying stock or index, their choices imply a forecast for the weeks ahead. That is because option trading is literally a 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 this insight is to understand the context in which the price behavior took place. The chart below depicts the price action for IBM's share price on Tuesday, illustrating the setup after the earnings report.
The one-month trend of the stock saw shares breaking through support in early June and trending lower before falling less than 1% on the day of the announcement and rising 1.5% the day after that. The price closed in the middle region depicted by the technical studies on this chart.
The 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 moved around but mostly held in an average range all month. This price move from IBM shares implies that investors may be gaining confidence in IBM moving 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 expecting a further move downwards going into earnings, based on the price trend for IBM approaching the bottom third of the 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 IBM would move upwards 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.
It is important to note that open interest on Tuesday featured nearly 287,000 call options compared to roughly 230,000 put options, demonstrating the ambivalence that option buyers had, with the percent of calls and puts nearly even. This normally implies that option traders expect price movement but are unsure of the direction.
After earnings, the volatility has decreased dramatically, but the number of put options in the open interest increased more than the number of call options. This signals that put options are being sold, rather than bought, creating a bullish sentiment.
For the strikes at the money and one step either direction, the put volume far outweighs the call volume. Out-of-the-money put option volume declines at a much faster rate than out-of-the-money call volume, signifying that more traders believe that IBM share prices will drift lower than those who believe share prices will head higher. This could also be that put options are being sold further out of the money, as traders don't believe that the share price will fall but are still able to capture lower-risk premium.
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 and put option pricing are in such a close range, with plenty of space on either side to run. This suggests that options buyers don't have a strong conviction about how the company will report. A surprising report could push prices dramatically in either direction.
These support and resistance levels show a large range of support for prices. As a result, it is possible that there could be a large move upward in the near future. After the previous earnings announcement, IBM shares rose by under 3.8% in the day following and continued the trend the following week. Investors may be expecting the same kind of move in price in the week after this announcement. Nearing the middle of 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 upward.
The effect of IBM's earnings report is significant to the market because of the company's key connection to the technology sector. IBM shares typically make mild moves after earnings, so the result doesn't move index prices directly.
However, no matter what the report says, it will likely have a significant impact on stocks in the technology sector. As one of the first major tech companies to release its earnings report for the quarter, IBM plays a part in setting the tone for the sector as a whole. How the market reacted to a positive report could affect similarly positive reports of other stocks in the sector such as Apple Inc. (AAPL), Microsoft Corporation (MSFT), and Cisco Systems, Inc. (CSCO). State Street's Technology Sector Index ETF (XLK) fell 1.4% the day the report was released, and State Street's S&P 500 index ETF (SPY) fell 1.5%.