Patient investors have kept the share prices for The Home Depot, Inc. (HD) in a defined range ahead of its quarterly earnings announcement. Because of this, option traders are taking advantage of the opportunity to sell option premium. That means they hope to collect profit from selling covered calls anticipating that the stock will not move strongly after earnings. This implies they they are not expecting a standout report – either good or bad.
There's no way to accurately predict the direction a stock will move after an earnings announcement. However, a comparison of the price action between stock prices and option trading activity shows that, if the company delivers a positive report, Home Depot shares could jump significantly, diverging away from its 20-day moving average in the first few days after the announcement. This could happen because option market makers have had to take the other side of the covered call trades, leaving them with an upward bias.
- Traders and investors have kept the price of Home Depot shares in a tight range heading into the announcement.
- The price has been closing near its 20-day moving average.
- Put and call option pricing is predicting roughly equal moves despite the significantly higher volume of calls traded.
- The volatility-based support and resistance levels allow for a strong move in either direction.
- This setup creates an opportunity for traders to profit from an unexpected result.
Option trading represents the activities of investors who want to protect their positions or speculators who want to profit from correctly forecasting unexpected moves in an underlying stock or index. That means option trading is literally a bet on market probabilities. By comparing the details of both stock and option price behavior, chart watchers can gain valuable insight, although it helps to understand the context in which this price behavior took place. The chart below depicts the price action for Home Depot's share price and the setup leading into the earnings report.
The one-month trend of the stock has the shares remaining in a medium range. It is notable that over the past month Home Depot fell to $270 per share at the beginning of February with only a slight drift higher as the announcement day draws near. The price closed in the middle region depicted by the technical studies on this chart. The studies are formed with 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 moved around but mostly held in an average range all month. This price move for Home Depot shares implies that investors expect little change from the upcoming report.
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 one to two weeks of trading on a daily chart.
In this context where the price trend for Home Depot has been holding in a middle range, chart watchers can recognize that traders and investors are expressing complacency going into earnings. That makes it important for chart watchers to determine whether the move is reflecting investors' expectations for a favorable earnings report or not.
Option trading details can provide additional information to help chart watchers form an opinion about investor expectations. Option traders are favoring calls over puts by a high margin. This normally suggests that investors are expecting good news from the company report. However, in this circumstance, traders appear to be expecting that Home Depot shares won't move strongly, up or down, 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, this channel indicator makes for an excellent visualization tool when charting historical volatility.
Option traders recognize that Home Depot shares are average and have priced their options as a bet that the stock will close within one of the two boxes depicted in the chart between today and Feb. 26, the Friday after the earnings report is released. The green-framed box represents the pricing that the call option sellers are offering. It implies a 71% chance that Home Depot shares will close inside this range by the end of the week if prices go higher. The red box represents the pricing for put options with a 74% probability if prices go lower on the announcement.
It is important to note that trading on Tuesday featured over 32,000 call options traded compared to roughly 10,000 put options, demonstrating the bias that option buyers had. Only 24% of the trades were put options. This unusually low amount normally implies that call option traders expect a jump in price. However, because the call box and the put box are equal in size, it tells us that the high percentage of call options traded has not skewed expectations higher. Chart watchers can assume that this is because many of the call options traded were initiated as covered calls. This circumstance implies a far more complacent outlook.
The purple lines on the chart are generated by a 10-day Keltner Channel study set at four times the ATR. This measure tends to create highly correlated regions of strong support and resistance in the price action. These regions show up when the channel lines make a noticeable turn within the previous three months. The levels that the turns mark are annotated in the chart below. What is notable in this chart is that the call and put pricing are in such a close range with plenty of space on either side to run. This suggests that option buyers don't have a strong conviction about how the company will report. Although investors and option traders do not expect it, a surprising report would push prices dramatically higher or lower.
These levels show a large range of support and resistance for prices. As a result of this, it is possible that any news, surprisingly bad or good, will catch investors by surprise and could generate an unusually large move. After the previous earnings announcement, Home Depot shares rose by under 1% in the days following. Investors may be expecting the same kind of small move in price after this announcement. With lots of room in the volatility range, share prices could rise or fall more than expected.
The effect of Home Depot's earnings report is influential to the market because of the company's key connection to the housing market. Home Depot shares typically make mild moves after earnings, so the result doesn't move index prices directly. However, no matter what the report says, it will likely have a significant impact on stocks in the consumer discretionary sector.
Now that more than 70% of the S&P 500 companies have reported earnings so far this season and a large majority have beaten estimates, investors will expect the same from Home Depot. Anything less would be a shock. A positive report could lift other stocks in the sector such as competitor Lowe's Companies, Inc. (LOW), The Walt Disney Company (DIS), or even Amazon.com, Inc. (AMZN). It could also affect exchange-traded funds (ETFs) such as State Street's Consumer Discretionary Select Sector SPDR Fund (XLY), and potentially State Street's SPDR S&P 500 ETF Trust (SPY).
The Bottom Line
Option traders on Home Depot are favoring call options by a strong margin over put options before the company's earnings announcement. Investors are clearly expecting only a mild move. If a surprisingly good report does materialize, Home Depot shares could lift into a new upward trend. The volatility price range size is enough to exceed both call and put pricing, allowing for a large move in either direction.
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