Earnings preview: Can Discover Financial Services beat again in 3Q?

Discover has a mixed history in the earnings confessional. During the past four quarters, the company has fallen short of analysts' estimates twice, and exceeded Wall Street's expectations twice. In the third quarter of 2008, Discover's profit of 37 cents per share narrowly edged out the consensus forecast of 35 cents per share.

As the credit card company's earnings date approaches, analysts have handed out bullish notes rather generously. Credit Suisse Wednesday raised its price target from $11 to $14, just one day after Sandler O'Neill boosted its own price target from $12 to $15. On Monday, Fox-Pitt upgraded DFS from "in line" to "outperform."

From a technical perspective, this outpouring of optimism seems richly deserved. DFS has added nearly 59% in 2009, and from its March 6 nadir of $4.73, the stock has surged 220%. Since then, the equity has enjoyed the support of its 10-unit and 20-unit daily and weekly moving averages.

Despite this impressive price action, there's still plenty of room for sentiment to improve toward DFS. Zacks reports that nine out of 14 analysts maintain a Hold, Sell, or Strong Sell rating on the security. Plus, the equity's average 12-month price target of $12.65 represents a notable discount to Tuesday's close of $15.14. This leaves ample opportunity for additional upgrades and price-target hikes post-earnings.

Investors are also skeptical toward the shares. Short interest rose by 6% during the most recent reporting period, and these bearish bets now account for 2% of the stock's float. Meanwhile, option traders on the International Securities Exchange (ISE) have bought to open 1.58 puts for every call on DFS during the past two weeks, revealing a pessimistic bias among speculative players.

However, not every trader feels confident enough to pick a directional bias ahead of earnings. Amid Tuesday's option volume on DFS was the initiation of a straddle, as two blocks of 117 contracts crossed the tape at 1:42 p.m. Eastern on the stock's September 15 put and call. Both legs were marked "spread," confirming their correlation.

In a long straddle, the trader expects the underlying equity to make a drastic move in one direction or the other, so it's a popular pre-earnings strategy. By buying to open a long call and a long put at the same strike, either bullish or bearish price moves can translate to profits. This particular straddle was opened for a net debit of $0.95, placing breakeven on the upside at $15.95 (the call strike plus the net debit) and on the downside at $14.05 (the put strike minus the net debit).

While this strategy might seem ideal, it's worth noting that the heightened expectations for a post-earnings move out of DFS means that it's not most opportune time to take up the buying end of a front-month options trade. The stock's September 15 put and call boast implied volatility of 82% and 72%, respectively, compared to the equity's one-month historical volatility of 40.9%. In other words, options on DFS are more expensive than usual at the moment.

Elizabeth Harrow is an analyst and financial writer in the research department at Schaeffer's Investment Research. She is featured in the video series Schaeffer's Daily Q&A on SchaeffersResearch.com.