Options Theory: Market Maker Move (MMM) and Earnings Gaps
Shareholders are obsessive about profits, as they should be. In the end, it’s how much money a company makes that really determines the true value of the enterprise. And that’s why every three months when public companies report their latest quarterly earnings, Wall Street pays attention.
Since most companies fiscal year jives with the calendar year, the four months where earnings announcement dominate are January, April, July, and October. Collectively this quartet is known as “earnings season.” Essentially, it’s the months after the end of each quarter.
Now, because the Street is so sensitive to a company’s earnings performance, they are quick to reward a stock that smashes expectations. Alternatively, they rapidly punish those that disappoint. But it’s not that black and white. Sometimes seemingly good earnings result in the stock selling off, and bad earnings cause the stock to rally. That’s why holding your stock into earnings is a crapshoot. Even if you knew what the company was going to report, you still don’t know how the fickle citizens of Wall Street will respond.
Since earning announcements take place outside of regular trading hours (9:30 AM — 4:00 PM EST) the reaction to the news is already priced-in by the next morning. This is why you’ll often see large price gaps in the stock chart on the day after earnings. Furthermore, this is why we suggest you exit any short-term positions in before the earnings release. Otherwise, you may wake up the next morning to a substantial loss.
Thanks to the options market it is possible to gauge just how much a stock is expected to gap after earnings. Rather than flying blind and having no idea if your stock will gap 5% or 25%, you can look at a few critical metrics displayed in the options chain to know the expected move beforehand.
If you’re using ThinkorSwim, the expected move for every expiration is displayed on the far right. After the implied volatility it shows the dollar range that the stock should trade within between now and expiration in parenthesis. Let’s use everyone’s favorite ETF, SPY, to illustrate.
SPY is trading for $267.55. The first expiration available is February, and only two days are remaining. The implied volatility is 20.51% which translates into an expected move of up/down $3.88. That means SPY should trade in a range between $271.43 and $263.67 for the next two days. To convert the expected dollar move into a percentage simply take $3.88 divided by the stock price ($3.88/$267.55 = 1.5%).
Based on current option premiums, SPY should move in a range of up/down 1.5% over the next two days.
You’ll notice I keep say SPY “should” move in a range of X. Allow me to be more specific. The expected move represents a one standard deviation (aka one sigma) range. That means there is a 68.2% chance (that’s the confidence interval) that SPY will remain in that field. If option premiums are accurate — and they usually are — then roughly seven out of ten times the stock will stay in the expected range.
Got it?
Now that you’ve got the basic idea let’s look at a stock that has earnings tonight — Goldcorp (GG). Its option premiums have risen dramatically ahead of the event, but what does that translate into as far as the expected move? Well, the Feb options with expire in two days have an implied volatility of 79.99% which turns into an expected move of up/down 75 cents. Since the stock is trading for $13.22, that’s roughly a 5.7% move between now and the end of the week.
The main problem with using this method to gauge the earnings gap is it doesn’t just estimate how much the stock will move overnight; it’s determining how much the stock will move between now and expiration. In this case, that’s two days from now.
This is where the Market Maker Move comes in. It is displayed at the top of the options chain in yellow (MMM). Since it’s only trying to gauge the overnight gap, it should always be smaller than the expected move for the first expiration available in the options chain. For Goldcorp, the MMM is up/down 58 cents. Again, with the stock trading for $13.22 that converts to a 4.4% move.
That is how much the collective wisdom on Wall Street is betting Goldcorp will move on earnings tonight.
What do you do with that information?
We’ll tackle that next time.
