Thursday, February 03, 2005

Investor Overreaction

I have thought for a long time that investors overreact to news, moving stock prices higher and lower than warranted. A recent example of this is eBay's stock price dropping 25% upon reporting quarterly earnings below analysts' estimates by a penny in January. With Amazon's earnings announcement coming Feb. 2, I thought that I would do a paper-based experiment to see if there might be a short-term way to make money off this type of investor behavior.

My strategy (all on paper--no real trading) was to go long both a call and put (straddle) struck at-the-money (Feb. 18 expiry), just before the earnings announcement. I had done my homework and observed that over the past eight quarters in 2003 and 2004, the 1-day changes in Amazon's stock price from pre- to post-announcement were: 1%, 15%, 15%, -9%, -7%, -5%, -13%, -12%. The average change is -2%, but the average change in absolute value terms (i.e., without regard to direction) is 10%. A long straddle position would allow me to profit from a large move either way, up or down.

With the stock price at 41.8 and a strike of 42.5, the call cost 2.0 and the put 2.6, giving a total option premium of 4.6, with implied volatility about 55%. After close of market, Amazon announced earnings. They missed by $0.04 and the stock dived 16% in after-hours trading, positioning me for a nice profit when closing out my straddle in the morning.

This morning (Feb. 3), with the stock price having dropped overnight from 41.8 to 35, I found that the call became worthless but I could sell the put for 7.40, giving me a "cool" 1-day profit of 61%. Clearly, had I actually done the trade, I would have profited like a bandit.

To see how I would have done under other possible outcomes, I run a few sensitivities, using pricing from the post-announcement market, with implied volatility now lower at 35% (less demand for options, less uncertainty since the news is out):

Change in Stock Price, Proceeds from Options Sale, Profit or Loss:
Down 20%, 9.05, profit of 97%
Down 10%, 5.05, profit of 10%
Unchanged, 2.80, loss of 39%
Up 10%, 4.15, loss of 10%
Up 20%, 7.75, profit of 68%

Like with most real-world distributions, the outcomes in the middle are more likely, meaning in this case that a lossy outcome is more likely than a profitable one. However, if the frequent losses are small and the occasional profits are large (like the movie industry with its few blockbusters that make up for all the duds), the expected outcome can be a profit. With the past two years as a guide, I construct a simple probability distribution,

Probability (stock price down 20%, down 10%, unchanged, up 10%, up 20%)
= (5%, 30%, 30%, 30%, 5%),

which gives an expected loss of 3%. Sure, there is big profit for the big moves, but the more frequent losses tenaciously eat all the way through the gains!

If the volatility had stayed high at 55%, the expected outcome would have been a gain of 20% using the same probability distribution. Going into my paper trade, I had expected the volatility to drop following the earnings announcement, but I was hoping that the drop would be small enough to permit some "excess profits" for even a retail investor like me. Unfortunately, it appears that the professionals (statistical arb boutiques like O'Connor, equity trading desks of investment banks, hedge funds and the like) have already arbitraged away any margins in this type of trade. I suspect that there may be small excess profits but that they can only consistently be realized by market-makers who do not have a bid-offer spread to contend with and who do not pay trading commissions.

Conclusion: The simple options trade I mention, while it can be highly profitable on days when a stock flies or plunges (as Amazon did after announcing earnings), should not be relied on for consistent profit. For investors with a long-term view, a better way to take advantage of sell-offs (investor overreaction) like we have seen for eBay and Amazon--situations when nothing fundamentally changes--would be simply to buy a few shares and patiently wait for the companies to execute on their business plans. (Disclosure: I own a few shares of both EBAY and AMZN and am in for the long haul.)

5 Comments:

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