Every time Lucy pulls the football away from Charlie Brown, I get angry….at Charlie Brown. After all this time, shouldn’t Charlie know better? Isn’t it his fault if he is continually surprised by things that he should be able to predict? I do not like to be surprised, especially by moves in my equities. Sometimes the surprise is unavoidable, but more often than not, what looks like a random event, is telegraphed if you only know where to look.
The behavior of Walgreens Boots Alliance (WBA) beautifully illustrates this point. On June 24, 2014, WBA (formerly WAG) announced earnings and the stock barely moved. A few weeks later on August 6, The stock gapped down after the company announced lowered 2016 guidance and that they were no longer considering re-domicile in Europe in order to create a tax inversion could potentially have saved the company Billions in taxes. Below, you can see these moves reflected on the chart.
Although the price action immediately preceding the drop is not bullish, the price chart itself gives no indication that a large gap is on the way. Surprise most likely caught traders who relied solely on technical analysis. On the other hand, anyone who followed the methodology recommended by Options Animal would have been prepared for a large move.
At OA, we teach traders to create a limited watch list of solid companies through the use of technical, sentimental and fundamental analysis. The list is manageable, and traders can follow the companies’ moves closely over time, getting to know it well. Once you know a company well, you are far less likely to be surprised by its moves. In the case of WBA, the company announced during the earnings conference call that it would be holding a second conference at the end of July or beginning of August to give further guidance. Anyone who had listened to the conference or read the transcript would have been forewarned that something significant was pending. Further, anyone who followed the news about the company would have been aware of the speculation that WBA was considering a changed domicile and a tax inversion. That decision had a high likelihood of moving stock.
In addition to the news and the conference call, The use of Sentimental Analysis would similarly have warned traders of an impending large move in WBA. An option’s Implied Volatility is a measure of the investment communities’ expectation of movement. When people think a stock is capable of a large move, options on that stock become more expensive. Many equities have a pattern of rising Implied Volatility before an earnings event, as those events often precipitate large moves. Because people anticipate a large move, they are willing to pay more for the options. Implied Volatility usually decreases after the event because once all the news is out, investors no longer expect a surprise that can cause a significant move. However, WBA’s IV did not fall after earnings; instead it continued to rise until the day of the announcement. This can easily be seen on the IV chart below. Implied Volatility is represented by the gold line.
You can clearly see the IV rise after the earnings with a peak at the time of the companies’ revised guidance. That peak corresponds with the gap down in the stock. Anyone watching the IV would have noticed that the stock was not behaving according to its usual pattern. You would have been alerted to do some research and find out what was going on and to make sure that any trades were hedged.
Following the news and reading the transcripts, understanding the companies’ business model, future plans and challenges takes more time than simply scanning a price chart, but it pays off by allowing you to seize opportunities better and avoid problems.