With stock volatility hovering near a pre-financial crisis low, some investors might see an opportunity to take a breather. To the derivatives strategists at Goldman Sachs, it’s an opportunity to reap outsized gains.
They recommend using the share price fluctuations normally associated with earnings season to one’s advantage. The key is identifying stocks for which expected post-earnings moves are being underpriced relative to recent history, Katherine Fogertey and the Goldman derivatives team wrote in a client note on Wednesday.
The firm’s preferred vehicle for betting on earnings is an options straddle, which involves the purchase of both call and put contracts. Then, if the stock price moves up dramatically, a trader can use the call option to buy shares at a big discount, while if the price drops far enough, the put option will instead turn a profit.
The strategy ultimately makes a profit as long as the underlying stock sees a significant move, regardless of direction, making it ideal for something as unpredictable as an earnings report.
Of course, this isn’t as easy as it might sound. Buying straddles on stocks in an indiscriminate fashion can be an exercise in futility if the call and put options are appropriately priced, and are correctly factoring in the likelihoods of big up or down moves in the stock price. But not all options are appropriately priced, and those are the companies to target, says Goldman, which notes that it’s still a “very rare” occurrence.
Goldman found that earnings season is a good time to try this strategy. The firm looked at more than 25,000 corporate earnings reports since 1996 and found that investors who bought straddles five days before earnings and closed the trades one day after made an average profit of 24% with a success rate of 56%. They ran a similar analysis more broadly for all stocks and saw an average profit of just 2% with a success rate of only 35%.
This earnings season, the following five companies have caught the firm’s eye, with options suggesting smaller or comparable up-or-down moves in their stock prices than have happened after recent earnings reports:
- GrubHub (GRUB), reporting April 27 — Options implying a 10% move vs. 11.3% median earnings move over the past eight quarters
- Parker-Hannifin (PH), reporting April 27 — Options implied move 3.4% vs. 3.3% median 8Q earnings move
- FireEye (FEYE), reporting May 2 — Options implied move 11.2% vs. 12.1% median 8Q earnings move
- Pioneer Natural Resources (PXD), reporting May 3 — Options implied move 4.2% vs. 4.2% median 8Q earnings move
- Universal Display (OLED), reporting May 4 — Options implied move 7.2% vs. 9.3% median 8Q earnings move
While the CBOE S&P 500 Volatility Index was already trading well below historical averages over the past few months, it’s been particularly low in recent trading sessions after the first round of the French election passed without any major surprises. After closing at 10.76 on Tuesday, the VIX is just 1.5 points from an all-time low reached in December 1993.