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Looking at Pre-earnings Order Flow

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With the end of the second quarter just a few days away, it won't be long before earnings reports flood the market from mid-July to mid-August. Options prices are typically very efficient and premiums "price-in" the potential post-earnings moves with higher implied volatility in the front-month options on companies that are due to report. It's often interesting to see the market expectations and the positioning in front of the news. Let's take a look at a recent example.

Lennar (LEN) is trading up 4.4% to $36.50 in the wake of the company's earnings report. Option flow heading into earnings was very heavy with 19K calls and 14K puts trading on the stock on Monday. Upside calls in July led the most actives, with a buyer paying $0.93 for the July 36-39 call spread in afternoon action when shares were near $35. They bought the July 36s for $1.61 and sold July 39s at $0.68, to open. The spread is now bid at $1.10. In this case, it appears that an investor made a smart directional bet in the homebuilder ahead of the results.

In addition to looking for bullish or bearish options trading in specific stocks ahead of earnings, the past track record around earnings if often intersting as well. For instance, as we can see from the graphic below, the average daily move in LEN over the past eight quarters is 4.7%, so today's move is mostly in-line with the past. Some stocks are simply bigger earnings movers compared to others. So, seeing what happened in the past is often an important indicator of what might happen in the future.
LEN Daily Contract Activity
Source: Trade Alert


Lastly, I like to see what the market is saying about the potential for volatility around a profit report. The easiest way is simply to look at the at-the-money straddle. In LEN, the July straddle was trading near 11% of spot ahead of the report. However, since there are stilll 24 days until expiration, some of that premium is due to time value. Therefore, we also look at the skew between the front-month and later expiratoin months to get an idea of the potential range for the stock post-earnings. The math lies outside of the scope of this article, but in this case, the market on LEN options was suggesting a standard deviation of about 7.6% on earnings, well above the median move near 4.7%.

In summary, some of the factors to consider when looking to enter or exit a positoin in front of an earnings report include 1) the directional bias being displayed in the order flow 2) what is the post-earnings move history 3) is the market pricing in for the potential for a big move. In the case of LEN, the directional order flow was bullish, and the market was implying a larger post-earnings move compared to previous quarters. It turns out, the directional flow seemed to foreshadow the move higher, but the premiums were a bit too jacked up compared to the stock's behavior around past earnings reports. Situations where there is strong directional sentiment and relatively low expectations (relative to past post-earnings moves) are the best trade set-ups around earnings. Of course, those are far and few between.

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