Although earnings season doesn’t “officially” start until Alcoa’s (AA) quarterly report kicks off the third-quarter championship round, you don’t have to wait until earnings season begins to start raking in profits of your own based on how well (or how poorly) publicly held companies perform.
The markets may be enduring triple-digit losses, but we just kicked off our very own earnings season with two triple-digit winners. And we’re just getting started!
As an options trader, no doubt you hear about earnings season when it comes around in mid-January, April, July and October. But do you know how to leverage this powerful time period to your advantage?
Learning the Earnings Game
Sure, the World Series and Super Bowl Sunday are much-anticipated. But personally, I can’t wait for the excitement of earnings season, because I get to watch my favorite sport four times a year … and double my money at least that many times, each time around!
Every publicly held company has to report not only their performance during the past quarter, but they also typically provide outlooks for the following quarter and possibly the full year as well.
No other market event offers more opportunities for traders to earn big bucks not only on companies’ fiscal hits and misses during the past three months, but also for the effect on shares from all of that “other” data that means so much to Wall Street.
Even missing analysts’ estimates by just a penny might send an otherwise-great stock sinking, while surpassing Wall Street’s expectations by just 1 cent per share can send the same stock soaring.
Many investors trade reactively during earnings season. That is, they buy the stocks of the companies that did well, and they offload their shares in the companies that might not have performed so well. That’s a lose-lose proposition — if you’re getting to the table, or leaving it, too late, then someone else is benefiting big-time.
This earnings season, it’s time for you to bank one winner after the next, selling your positions to the latecomers.
It’s time to make earnings season the most-profitable time of your year!
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It’s all About Expectations … Yours
Earnings are the truth serum for a business built on lies, hype and hysteria. Quite simply, if you can separate truth from fiction before earnings are “confessed,” you can double — even triple — your money. And you can do it in as little as two or three days!
Forecasts made just weeks ago already look ludicrous. Guidance given confidently before the bailout is already irrelevant. And in the next few weeks, almost every CEO of every publicly traded company in the land will get in line outside the Earnings Confessional and tell the truth to the world.
So how do you know what stocks are going to move? The answer lies in expectations.
It’s not about whether a company beats earnings estimates; it’s whether they beat the market’s expectations. This is a time when the reaction to news is more important than the news itself.
From a ‘Whisper’ to a Screaming Buy (or Sell)
Although analysts go on record with their expectations (or lack thereof) of a company’s quarterly performance, even if you’re listening closely, you’re only hearing half the story. The “whisper number” is the off-the-record earnings-per-share (EPS) estimate that Wall Street professionals come up with and perhaps share with their favored clients.
We’ve all seen a stock drop in price despite an earnings report that met or even beat expectations. Or one that rallies furiously after merely meeting expectations. Why does the stock seemingly move against the fundamentals?
The answer is often contained in the differing sentiment environments surrounding the two stocks prior to the event. In one case, the sentiment may have been excessively bullish heading into the event, which creates high expectations of a blowout report.
This also creates what is called a “crowded trade,” which leaves little money to flow into the stock after the earnings release, no matter how positive the report.
Here’s the trading tip you need to take away from this: A stock with relatively low expectations stands a good chance of rallying, as there is plenty of sideline cash available to boost the price.
Conversely, high expectations (i.e., the crowded trade) can put downward pressure on a stock, as there is little to no sideline cash to drive the price higher. In fact, the path of least resistance for cash is to flow out of the stock, resulting in declining prices.
How We Tripled Our Money in 4 Trading Days
A perfect example of this is a trade we just closed in an agricultural player that served as fertile ground for a solid, earnings-based play with put options.
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Last year at this time, the “ag” trade was all the rage, but it’s been a different story for much of 2008. Monsanto (MON) has dropped about 5% for the year, after being up as much as 30% in June, and all signs pointed to the trade having some more unwinding to do in the shorter term.
Normally, I like to play our earnings trades a few days before the company reports. But Monsanto caught my eye as a potentially explosive trading opportunity, as the stock was destined for a decline into earnings based on several factors.
With the company’s earnings announcement due Oct. 8, the consensus expectation among Wall Street analysts called for a loss of 13 cents per share — a 5-cent improvement from last year.
Analysts are in love with MON, as seven of nine rated the shares a “Buy” and no one considered the stock a “Sell.”
Keep in mind that expectations per se don’t necessarily matter — it’s whether they are, or even can be, at the very least met. This leaves plenty of room for downgrades.
MON’s recent slump from its June high does not justify the optimism I was seeing among analysts and the options markets. With more potential pressure being put on commodities and the ag trade in the short term, I was looking for MON to decline to at least the $90 mark.
The put/call ratio has fallen for the past month and showed signs of reversing. That is, MON had become crowded with calls, so I decided it was time to jump on this name before the puts started to increase in strength.
We got to the party just in time. On Sept. 29, I recommended buying the MON Oct 105 Puts for $7.50. Shares had fallen from $121 just days earlier to $103 when we initiated the position, and continued dropping like a stone.
In fact, on Oct. 2 — just four trading days later, MON was downgraded by Merrill Lynch to “Neutral” from “Buy.”
No reason was given, but frankly, I didn’t care, because the stock was down almost 20% and our option was deep in-the-money. We closed the puts at $24, a sweet 220% gain in just under a week!
Shares have fallen further to $75, pushing the puts into the $29 area. But with this crazy market, where anything can (and does) happen in the span of one trading day, I’m not one to pass up a fantastic profit like the one we banked.
Besides, there are plenty more opportunities coming our way. Find out how you can get them delivered straight to your inbox — FREE!
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‘Earning’ Your Trading Stripes
The key to finding the most optimal earnings plays is to find situations in which expectations are either high or low and are running counter to the technicals.
This is especially important during earnings season, because sentiment tends to be polarized prior to an announcement.
High expectations (low put/call ratio, low short interest, and high percentage of analyst “Buy” recommendations) usually require a company to blow out earnings in order for the stock to rally. Such stocks are vulnerable to disappointments if the company simply meets estimates or issues a tepid outlook for next quarter.
On the other hand, low expectations (high put/call ratio, high short interest, and a low “Buy” rating percentage) mean that a stock will not have to work as hard to overcome sentiment.
Such stocks are less crowded, and thus have a greater potential to rally. Thus, capturing the sentiment backdrop prior to earnings, along with assessing the technicals and the company’s past earnings history, are the keys underlying your success.
Keep in mind that, even though earnings season is only acknowledged as a quarterly event, only two-thirds of the S&P 500 (SPX) companies report during that time. One or more companies makes an announcement practically every trading day throughout the year, as sectors like the banks and retailers operate their fiscal years/quarters outside of the calendar year/quarter.
So, if you’re looking to profit on your schedule, on any day of the year, playing the earnings game can earn you some decent options-trading income, whether the underlying companies are hitting the mark or are way off-target.
