Optimistic investors had bid up the share prices of Cisco Systems, Inc. (CSCO) ahead of the company’s fiscal fourth quarter earnings announcement. At first glance, it appears that option traders are positioned for a negative move, as the number of sold call options is rising in the open interest. The unusual option activity could create a strong downward trend in the price action if CSCO delivers a negative earnings surprise.
The open interest for CSCO shows an increasing number of call options being sold, and option premiums are unusually high right now. Trading volumes indicate that traders have been selling calls and buying puts in anticipation of a negative earnings report. Unwinding these bets could place unexpected upward pressure on the share price of CSCO.
It is challenging to accurately predict the direction a stock will move after earnings. However, a comparison between the stock’s option activity and price action shows that, if CSCO delivers a positive report, the company’s share price could rise, moving further above its 20-day moving average after the announcement. This could happen because options are priced for a downward move, but unexpected good news could catch traders by surprise and create a rapid rise in share price.
The share price has recently been closing above its 20-day moving average.
Call and put pricing is predicting a stronger move to the downside.
The volatility-based support and resistance levels allow for a stronger move to the downside.
This setup creates an opportunity for traders to profit from an unexpected earnings result.
A comparison between the details of both stock price and option behavior can grant chart watchers valuable insight. However, it is necessary to understand the context in which this price behavior took place. The chart below depicts the price action for the CSCO share price as of Aug. 16. This created the setup leading into the earnings report.
Over the past month, the trend for CSCO stock has the share price remaining solidly above its 20-day moving average, closing in the middle of the top third of the volatility range. In this time period, it’s notable that the lowest CSCO share price was near $53 in mid-July, whereas the highest share price was $56 in mid-August. The price closed in the upper region depicted by the technical studies in this chart.
The studies are formed by 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 risen closer to the 20-day moving average in the week before earnings. This price move from CSCO shares implies that investors’ confidence is growing as the earnings report approaches.
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 two to four weeks of trading on a daily chart.
In this context where the price trend for CSCO has closed above its 20-day moving average, chart watchers can recognize that traders and investors are expressing growing confidence going into earnings. It’s notable that, in the week before earnings, CSCO’s share price has found a stable level, well above the 20-day moving average. That makes it important for chart watchers to determine whether the move is reflecting investors’ expectations for favorable earnings or not.
Option trading details can provide chart watchers with additional context to help them form an opinion about investor expectations. Recently, option traders are favoring calls over puts by a narrow margin. On Monday, there were over 40,000 calls traded opposed to over 33,000 puts. Normally, this volume indicates that traders are feeling bullish toward the earnings report.
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, then this channel indicator makes for an excellent visualization tool when charting historical volatility.
Option traders recognize that CSCO shares are in an above average range 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 Aug. 20, the Friday after the earnings report is released. The green-framed box represents the pricing that call option sellers are offering. It implies a 34% probability that CSCO 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 34% chance if prices go lower on the announcement.
It is necessary to note that the open interest featured over 730,000 calls to over 653,000 puts, demonstrating the bias that option traders had, as traders narrowly favored calls over puts. While the open interest and recent volumes show more calls than inputs being traded, it is important to note that implied volatility has been falling for these call options, which implies that they are being sold, rather than bought. This reflects a bearish sentiment around CSCO earnings. However, because the call box and put box are relatively equal in size, it tells us that the high percentage of sold call options has only mildly skewed expectations lower. A far more complacent outlook is implied.
The purple lines on the chart are generated by a 10-day Keltner Channel study set at 4 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 to run either way but with more room to the downside. This suggests that option buyers don’t have a strong conviction about how the company will report, even though recent call volumes outweigh put volume. Although investors and option traders do not expect it, a surprising report would push prices dramatically higher or lower.
These support and resistance levels show a large range of support and resistance for prices. As a result, 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, CSCO shares rose less than 1% the day after earnings and continued to rise the following week. Investors may be expecting a similar positive move in the price after this announcement. With plenty of room in the volatility range, share prices could rise or fall more than expected.
Cisco is a leader in the technology sector, and as a member of the S&P 500, its earnings results have the potential to impact indexes directly. No matter what the report says, it’s likely to have an effect on stocks in the technology sector. A positive report could lift other stocks in the sector such as NVIDIA Corporation (NVDA), Adobe Inc. (ADBE), or Accenture plc (ACN). It could also affect exchange traded funds (ETFs) such as Invesco’s QQQ Trust ETF (QQQ), State Street’s S&P 500 ETF Trust (SPY), or the iShares U.S. Telecommunications ETF (IYZ).