After The Procter & Gamble Company (PG) reported that it had beaten analysts' predictions for its fiscal fourth quarter earnings results, option traders are taking actions that imply they think the share price will move higher in the future. This may come as a slight surprise considering that the share price fell less than 1% the day after the announcement.
PG reported earnings per share (EPS) of $1.13 and revenue of $18.95 billion, beating analysts' expectations calling for EPS of $1.08 and revenue of $18.41 billion. Prior to the announcement, investors had slightly bid up the share price of PG to an elevated range, with a noticeably large volume of call options in the open interest.
Option trading volumes indicate that traders had been buying calls and selling puts; however, option activity after earnings indicates that traders are still confident in PG's share price going forward. That's because the price action has remained above the 20-day moving average, while option activity implies that traders continue to buy calls and sell puts.
- Traders and investors sold shares of PG following the earnings announcement, as the stock fell less than 1%.
- The share price of PG 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 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 insight into option trading is to understand the context in which the price movement took place. The chart below illustrates the price action for PG's share price as of Aug. 6, illustrating the setup after the earnings report.
The one-month trend of the stock saw the share price both testing the upper bounds of the volatility range and bouncing off the 20-day moving average, before closing in the upper third 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 fallen from the upper portion of this range to the middle bounds, before rising back toward the upper third of the range. This price move from PG shares implies that investors haven't lost confidence in the share price of PG 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 optimism going into earnings, based on the price trend for PG closing above it’s 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 PG shares 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.
The recent activity of options traders implies that they consider PG 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 PG 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 33% chance that prices could close above this red box, it appears that buyers are willing to take those long odds.
It is important to note that open interest on Aug. 6 featured nearly 262,000 call options compared to over 148,000 puts, demonstrating the bias that option buyers had, as over 60% of the options were calls. This normally implies that option traders expect upwards price movement. After earnings, the volatility has decreased dramatically, but the number of call options in the open interest increased, and the put/call ratio is dropping. This signals a bullish 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, which would signify that more traders believe that PG share prices will fall than those who believe share prices will rise. However, it should be noted that the implied volatility of this put option volume is also declining, indicating that put options, while still being traded in large volumes, are being sold more than purchased.
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 PG option traders 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 the stock will rise modestly in price, making the purchased call option more valuable in the future. The best-case scenario would be for PG'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 current bullish sentiment, buying the Sept. 10 $140 call costs $3.80 and has a breakeven price of $143.80. Selling the Sept. 10 $145 will deliver a credit of $0.84, with a breakeven price of $145.84. After buying the $140 and selling the $145, the net debit for this trade is $2.96, or $296 per contract. The breakeven price of the trade at expiration is $142.96 (data snapshot as of 3:59 EDT, Aug. 6, 2021). The chart below illustrates the setup for this particular debit call spread.
No strategy is without risk. The maximum risk on this trade is the total debit paid for the trade, or $296 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 buying a naked call option. For this particular example, the maximum potential gain is $204. The potential return on risk for this trade can be calculated as: $204 / $296 = 69%.
Procter & Gamble beat analysts' expectations for both EPS and revenues. The share price fell less than 1% the day after the announcement and has remained in the upper third of the volatility range, closing 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.