Market Direction Mid Week Update©

Market Direction: BULLISH alert issued 11/10/2016

Earnings could be volatile in the 3rd quarter... 

Third-quarter earnings season is widely expected to extend the stock market’s streak of better-than-expected corporate results, potentially setting up even more gains, but that doesn’t mean that the recent trend of quiet trading will continue.

Investors, based on what is currently implied by the options market, seem to be playing down the potential for volatility in the season, according to Goldman Sachs, which noted that third-quarter results “are typically the most stock moving of the year.”

The investment bank credited this to a number of factors, including the fact that many companies issue comments on their outlook for the following year, the focus on year-to-date performance going into the final months of the year, and issues related to seasonal demand. “However, option investors not yet pricing in this seasonal pick up in earnings moves,” wrote Katherine Fogertey, a Goldman options strategist.

Many companies are scheduled to report this week—including a number of major financial firms, among them J.P. Morgan Chase & Co. JPM, -0.30% Citigroup Inc. C, -0.32% Bank of America Corp. BAC, -0.39% and Wells Fargo & Co. WFC, +0.09% —while dozens of additional names will release their results before the end of the month.

Read: Third-quarter earnings seen as ‘an easy beat,’ could set up more stock market records

Goldman recommended investors buy straddles going into the results, referring to an options strategy where an investor simultaneously makes a bullish bet by buying a call option and a bearish bet by buying a put option at the same strike price. This is essentially a bet on volatility, not direction, as the buyer is expecting the stock to move by a certain amount within a set time, as opposed to in a specific way. A call option gives the holder the right but not the obligation to buy the underlying security at a set “strike price” by a certain date. A put option works the same way, but gives the holder the right, but not the obligation, to sell the underlying security.

Historically, buying a straddle on a stock whose expected volatility is low relative to historical averages has yielded more than 10 times the move of other strategies, the firm wrote.

“While it is very rare that a straddle costs less than the prior earnings day move, those investors that purchased them five days before earnings and closing the day after could have realized an average profit of 24% with a hit rate of 56%,” it wrote in a note to clients. “This is significantly greater than the returns from buying options (strangles) on all stocks broadly regardless of this signal. In fact, buying the closest listed strangle for all stocks five days ahead of earnings and closing the day after produced just a 2% profit on average, and was profitable only 35% of the time.”

Among the specific trades Goldman named, it listed IBM IBM, -0.59% McDonald’s MCD, +1.60% Microsoft MSFT, +0.17% and Netflix NFLX, -0.07%  as stocks that the straddle strategy could be profitable on.

Read: Overseas demand set to drive third-quarter earnings

IBM, over the past eight quarters, has had a median earnings move of 4.5% (including both rises and falls), but the options market is currently pricing in a 4.1% move. Options on McDonald’s are pricing in a 3.2% move, below the eight-quarter median of 3.8%. For Microsoft, the implied move of 4% is below the historical median of 4.8%.

Investors are expecting a volatile result from Netflix’s earnings—9.7%—but this is below the stock’s median move of 10.6%.

“Buying the Netflix straddle five business days ahead of earnings has generated an average profit of 22% and was profitable in 52% of the quarters going back past 11 years,” Goldman wrote.

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The all-time highs since our initial recommendation to go LONG this market. Here is how the markets have performed:

Stock Market Direction Recommendation (9/21/2017)
Dow	up 513.66 points a 2.30% gain	10/11/17
Nasdaq	up 181.52 points a 2.83% gain	10/11/17
S&P 500	up 54.64 points a 2.19% gain	10/11/17

Related Link: http://www.stockmarket-direction.com/