Earnings season has begun. My favorite game at the moment is short earnings on Twitter (NYSE:TWTR). Timed market subscribers received the show early on.
Nasdaq
2:1, support the Bears
The shorts of this trade offer a kulling opportunity. That said, at least from statistical analysis, risk/reward is good for the bears. For example, the average downside of first-quarter earnings was $7.29 and the average upside was $3.50, which gives the bears an almost 2:1 advantage in terms of potential earnings.
More interestingly, the current cost of a parity spanning transaction covering the TWTR earnings date is $6.35. In other words, the market expects the price to be $6.35. If we were to go short, then the option was undervalued by about 15%, which is rare in terms of returns. Options tend to be overvalued around the earnings date, which is why short jumps have proven to be a profitable strategy. That is, we can speculate on TWTR with long puts without worrying too much about whether we're paying too much for the options.
As for probabilities, TWTR behaves rather randomly on Q1. That said, unlike our other earnings deals, we don't have a seasonal probability advantage here (though, as you'll see later, I have other reasons and I believe TWTR will be sold off in this quarter's earnings). This gameplay relies more on the risk/reward characteristic advantages of shorting versus longing – than on probability.
Seasonal weakness
As you can see, over time, TWTR behaves very randomly – like a random walk. TWTR has been essentially flat since its IPO in 2013. However, TWTR fell an average of 15% in April, making this month (the month covering the company's first quarter earnings report) an opportunity to go short.
Damon Veria
However, the current state of the stock is very interesting before the gains. The fact that TWTR's earnings were much higher than expected is likely to be largely due to Elon Musk's bid to buy the company. As earnings traders, we are not particularly concerned or interested in this development, except that the company has remained largely unchanged in the event of rising stock prices.
In other words, TWTR's stock price is overbought before it makes a profit. We want to see something like this go into profitable shorts because it gives us more room to make a profit. The basic theory is that earnings and guidance drive most of the price action after earnings, and the hype before earnings can artificially inflate stock prices immediately before new information fundamentally changes stock valuations.
Poor financial position
In this case, the new information is earnings data and forward guidance. I believe this will be seen as a reminder to investors that TWTR has an uphill battle on the financial side. The company's quarterly earnings per share declined, operating margins were negative, and the price-to-book ratio was more than double the industry average.
Simple Wall Street
Even if investors speculate that Musk will reshape Twitter's business model, they will have to admit from a fundamental perspective that the stock is currently overpriced. Moving from negative to positive margins can take years, which has a significant impact on most valuation models. Analysts' average forecasts won't be profitable until the end of 2023.
It's simply Wall Street
I believe the earnings from the first quarter will be a wake-up call for TWTR investors. Given Musk's development, the phenomenon of buying rumors and selling news is the name of the game here. But most importantly, we're playing with a long-term probabilistic model that puts us on either side with a better risk/reward situation.
Risk-backed games
For now, the best side is the bears. The Musk-based earnings rally just made the game more timely. I recommend the following gameplay:
Sell 1x May20 $55 put @9.50
Buy 2x May20 $48 Put @4.85x2=9.70
(Option prices as of April 21)
Therefore, the total cost of the strategy is only $20. However, you get unlimited downside risk in a potential TWTR sell-off. The maximum risk is $700, which can happen if TWTR trades at exactly $48 before May 20.
If the TWTR rises above $55, your maximum loss is only $20. The reason I chose $55 was to pay for the expected purchase price. For every $1 move below $48, your expected gain is $100. The $48-55 area is a danger zone, resulting in losses ranging from $20 to $700.
If you want to play more easily with the lowest maximum risk, simply buy may20's $48 put option for $4.85 each. If the TWTR is above $48, your total risk will be realized, which is not conducive to the recommended gameplay above, if the TWTR moves upwards, more than $50, it will only lose the same amount. So if TWTR yields go up, long puts give you less leeway, but they're cheaper and easier — and undervalued, at least from my analysis.