Sunday, January 26, 2014

Apple (AAPL) - Earnings Preview: Has the Option Market Mis-priced the Risk in Earnings?

AAPL closed Friday trading at $546.07, down 1.8% with IV30™ up 7.1%. The Symbol Summary is included below.

Provided by Livevol

I have written about AAPL extensively over the years and I highly recommend reading the older posts as we saw the firm literally change in front of our eyes from one firm to another with respect to risk as perceived by the market.

You can read any of the prior posts by clicking on the titles below. For a slightly quicker review, you can go to the last one listed (9-11-2013), which summarizes all of the prior posts (I have highlighted that one in yellow).

But today, I will focus on earnings and how the option market is pricing it... And there is a story...


Apple (AAPL) - Have We Moved into a Totally New Volatility Paradigm for This Company? Has Everything Changed?

Apple (AAPL) - Everything has Changed. The Old AAPL is No More. The New AAPL is a Riskier Entity and the Market Doesn't Know What that Means Yet.

Apple (AAPL) - "Just the Facts Ma'am" -- Well, that Supports the Opinion: "Everything has Changed. The Old AAPL is No More."

Apple (AAPL) - This Just Isn't the Company it Used to Be... And it Never Will Be Again.

Apple (AAPL) - Earnings Preview Reveals Lots of Information; But There is No More 'Old AAPL' -- That's Not Good or Bad... It Just is.

Apple (AAPL) - Post Earnings Analysis; Risk Paradigm Shift Over; Now the Market Gets It

Apple (AAPL) - Part 7 (The End): This Just Isn't the Company it Used to Be... And it Never Will Be Again.

Apple (AAPL) - Earnings Preview and a Remarkable Risk Profile Change... For Now...


Today: 1-26-2014

Just to be clear... really clear...

This is not advice.  This is analysis.  And... this is NOT Netflix.  I have no position in AAPL (unlike NFLX and TWTR at the time of those blogs).

We just got through an extraordinary examination of NFLX which looked very... very similar to how AAPL looks pre-earnings right now.  But, don't confuse the two! AAPL is an established giant, NFLX is a play on growth on top of growth. Two very different animals.

To read the extraordinary NFLX post and aftermath, you can click on the title below.  One of my favorites...

Netflix (NFLX) - Earnings Preview: "Less Risk in This Firm Now than In the Last Two-Years." Do You Agree? I'm Not Sure I Do.

And to read the wild mis-pricing of TWTR options, you can read this post:
Twitter (TWTR) - How the Option Market Totally Blew It, And We Knew it Two-Weeks Ago.

Let's start the AAPL analysis with the Charts Tab (two-years), below. The top portion is the stock price, the bottom is the vol (IV30™ - red vs HV20™ - blue vs HV180™ - pink).

Provided by Livevol

On the stock side we all know the story. The stock saw prices above $700, then prices below $400, and now we're in a relative equilibrium of ~$550.  AAPL is still the largest company in the world by market capitalization (by a lot) and the cash it has on hand is about the size of Citigroup's (C) entire market cap at ~ $150 billion.

But this is a volatility note based on earnings, and there is a lot to see -- both in the overall volatility and the skew. Let's turn to the IV30™ chart in isolation, below for the same time period (two-years).

Provided by Livevol

The blue "E" icons represent earnings dates, which is where I want to focus. In fact, I want to focus on it so much, I have included the same chart below, with just the earnings date vols highlighted.

Provided by Livevol

What We See
The horizontal line I drew in makes it easier to see the current level of the implied (as of Sunday afternoon) relative to the last two-years.  And what do we see?...

The level of the implied volatility (i.e. the level of the risk reflected by the option market) for this earnings release is lower than six of the last seven events.  The last time volatility was below this level into earnings was the summer of 2013.  The stock moved from $418.99 to $440.51 in one day and the weekly options priced in a ~$19.50 move.  So, in English, the stock moved more than the risk the option market reflected, but it was not a wild mis-pricing -- in fact, it was pretty darn close.

But what about now?... Is the overall market different today then it was in July of last year?


How about the overall risk in the market aka VIX.

7-23-2013: VIX spot closed at 12.66%
1-26-2014: VIX spot closed at 18.14%

So the VIX is 43% higher as of Friday's close than it was on 7-23-2013 (the last time earnings volatility for AAPL was below the current level).

So now the question becomes more complex: "Does AAPL have less earnings risk now in its shares than six of the last seven earnings and for the one outlier, should the risk be this low given that the VIX is 43% higher?"

I honestly don't know.  But the option market says: Yes.

I question that conclusion, but time will tell.

But there are some mitigating circumstances, namely, AAPL did release a report a little while back discussing sales in China and that report did show record sales. That report reduces risk, not because it was good (or bad), but because it reduced uncertainty.  This is a major red herring in the vol analysis.

But... that was a "a little while back." Also, AAPL is supposed to break new highs in China (iPhone 5C anyone?)... if the firm didn't break highs it would prove a cataclysmic failure.  The question is not if new revenue highs will be reached, but if those revenues will meet (or beat) expectations.

Remember a stock price is the present value of all future expected free cash flows (plus cash, debt etc). It's the expectations that matter.  So what are the expectations:

AAPL's guidance on revenue range is $55B - $58B for the quarter.  That's the top line.  I see estimates ranging from high $40's to low $60's... So, basically, no strong consensus around AAPL's guidance.

No consensus means risk on both sides, and guess what... The option market does reflect two tail risk.  Check out the Skew Tab, below.

Provided by Livevol

We can see that for the three weekly expiries and Feb monthly (dark blue), all the option cycles show a parabolic skew where the option market reflects greater risk in the wings.  This skew shape is abnormal.

To read more about skew and what it id you can click on the title below:
Understanding Option Skew -- What it is and Why it Exists

So now we have a fascinating situation where the risk in AAPL shares as reflected by the option market is lower than six of the last seven earnings cycles while the VIX is substantially higher now than that one outlier when volatility was lower.  We have a small window into China sales due to a prior release (which should reduce the volatility i.e. uncertainty), but we also have a window into a slowing Chinese economy... and slowing may be an understatement.  The Eurozone is also growing much slower than anticipated (see Germany's last GDP report).

You can read an old post from more than a year ago about China here:
Has the Chinese Apocalypse Started? Is China on the Cusp of a Deflationary Vortex?

Let's look at the Options Tab as of the close Friday and see where AAPL ends up on Tuesday.  Will the option market price it nearly perfectly like in July of 2013, or... not...

Provided by Livevol

The at-the-money ($545 strike) Jan 31 weekly options price a range of ~ [$515, $575] by the end of trading on Jan 30.  We'll see...

One last reminder... this is different than NFLX even though the vol set-up looks dangerously similar. The results may be the same (i.e. a huge move off of low implied volatility - a move which could be up or down), but the street is looking for totally different things from these two companies.

This is trade analysis, not a recommendation.

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1 comment:

  1. Good analysis Ophir! Could you take a look at CMG and BWLD & share your thoughts?