Big earnings week, and the power of implied volatility
10/24/17

The markets have kicked off one of the biggest earnings weeks of the year. Sometimes traders are comfortable with uncertainty risk before a company’s earnings report…and sometimes they’re not. One way to identify where the markets price in the risk of uncertainty is in the prices of the options. Here’s how we saw this disparity of uncertainty and risk play out in the restaurant sector this week:

McDonald’s (NYSE: MCD) reported earnings this morning. Yesterday, the implied volatility chart of McDonald’s options was relatively unskewed and even:

McDonald's (MCD) implied volatility 10/27/17 - 12/1/17

Source: OptionsHouse by E*TRADE

The relatively low lines told traders the markets weren’t pricing in a lot of uncertainty risk that MCD would move dramatically in either direction.

However, this was not the case for Chipotle Mexican Grill (NASDAQ: CMG). Chipotle is set to report earnings today after close. With Chipotle stock hovering near $322.50, the CMG October 27 $322.50 straddle (which is the near-term at-the-money straddle) was trading around $19.75. This implies that markets are pricing in a potential $19.75 gap move in either direction away from the $322.50 strike price.

The implied volatility chart for CMG looked like this:

Chipotle Mexican Grill (CMG) implied volatility 10/27/17 - 12/17/17

Source: OptionsHouse by E*TRADE

Notice how much higher the short term implied volatility is compared to other expirations. Doing the math, the markets are pricing in a potential 6% gap move in CMG either up or down ($19.75/$322.50 = .06, or 6%), versus a roughly 2% move for MCD. If a trader bought the CMG $322.50 straddle for $19.75, to make a profit that trader would need CMG stock the drop below $302.75 (322.50 - $19.75) or rise above $342.25 ($322.50 + $19.75).

The risk versus reward options graph for the buyer of the CMG $322.50 straddle looks like this:

CMG risk/reward

Source: OptionsHouse by E*TRADE

Some would say that’s a ton of dough between the current price and breakeven in either direction.

So why the big difference between MCD and CMG? Well, it could be because most analysts seem comfortable that there will be no surprises coming out of the MCD earnings report. However, some analysts are exercising caution going into Chipotle's earnings following recent negative estimate revisions.2

Bottom line: Earnings season can create trading opportunities if you know where to look, and checking out implied volatility certainly helps identify possible big swings. In this case, it’s clear not all restaurants trade the same, and even within the same category one can find wildly different trading scenarios.

 

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1. Zacks: Key Predictions for Q3 Earnings Reports of MCD & CMG. 10/23/27.