When International Business Machines Corporation (IBM) released its fourth-quarter 2020 earnings report yesterday after the market closed, traders in the post-market session sold the share price down as low as $122.25 shortly thereafter. This was a larger decline compared with what option sellers were expecting before the earnings announcement. The downward move was much larger than the usual trading range for IBM going into the earnings announcement. A move of this magnitude may imply a continued downward trend in the days and weeks ahead.
- IBM beat the profit target but missed the revenue target.
- Traders had expected IBM to move higher or at least stay above $126.
- Expected trading ranges shifted significantly lower.
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 that 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 IBM's share price and the setup leading into the earnings report.
The six-week trend of the stock was mildly higher as IBM climbed from $123 per share at the beginning of December to $131 per share the day before the announcement. The Keltner Channel indicators on the chart depict price levels that represent a multiple of the Average True Range (ATR) for the stock. IBM's upward price move was larger than four times the ATR from its original price in December.
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.
Using this as a backdrop makes it easy to show how the price trend for IBM stayed within a quiet range during this period. Although it does happen that IBM makes a big price jump beyond three times the ATR multiple, such moves are the exception and seem to occur less than 25% of the time. Furthermore, when they do occur, lately they have been a bearish indication.
The Keltner Channel indicator displays a set of semi-parallel lines based on a 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 recognizing that IBM had been in a quiet trading range may have assumed that the stock would make a large move higher after the earnings announcement. Trading on the day before earnings featured over 156,000 call options traded compared to roughly 52,000 put options, demonstrating the bias that option buyers had.
Clearly, the option traders were expecting very positive good news—so much so that 48% of those option trades were made on strike prices more than three ATR multiples above the closing price. The chart below depicts the option price ranges implied by all option trading before earnings.
The range option sellers expected for the announcement (shown by blue lines) was between a high of $136.47 and a low of $125.23. The option prices also implied that there was only a 25% chance that the price would go below $122 or above $138. IBM's average implied volatility score at that time was near 35%. The way option sellers had set prices before earnings, the options also implied the probability that the share price would land within the range of $139 at the high or $120 at the low by the end of the following week.
The earnings report included the key details that IBM beat its profit target by reporting $2.06 of earnings per share (EPS) compared to analysts' expectations of $1.81. However, the company missed its revenue target with only $20.37 billion in sales compared to $20.68 billion expected. The company announced that it expects to see revenue growth in 2021, but investors didn't seem to focus on anything other than the missed revenue target. The chart below shows how the price opened today and the adjusted probability range based on the market's reaction to the earnings announcement.
The price opened Friday at $120.70, lower than any price the stock has traded since before December. This reaction brought the stock several ATR multiples lower than the Keltner Channel average price. The price continued to fall after the opening the next day and broke beyond the 75% probability range predicted by the previous day's option trading. Meanwhile, the pricing for options in the following week shifted the implied price range lower, forecasting the possibility that the stock may trend downward.
Early in the trading session today, nearly 150,000 calls were traded compared to 84,000 put contracts, suggesting that traders are now more bearish than they were on IBM.
IBM is no longer the bellwether stock that it used to be, but it may be that the news of IBM's revenue miss will add to a more skeptical mood among investors if other technology companies also report results below expectations. Unless this happens, IBM's results are not likely to have any large impact on the broad market exchange traded funds (ETFs) such as the State Street's SPDR S&P 500 ETF Trust (SPY). Surprisingly, many investors remain optimistic, as evidenced by the large number of calls being purchased.
The Bottom Line
Option traders heavily bought IBM call options before the earnings announcement, expecting very good news from the company. However, the company's report surprised traders and investors, and IBM fell 7% after hours. With the following day's option trading reflecting a shift lower in the forecast, investors may be expected to take a more pessimistic outlook on the stock.