We often talk about buying call or put options on a stock before earnings with the anticipation of a big move. We’ll look at a stock’s post-earnings performance history, the sentiment heading into the earnings report, support and resistance levels on the chart, the overall fundamentals for the company and other factors, all in an effort to determine both the direction and magnitude of the move.
With all those moving pieces, it’s an inexact science at best. Our goal is to attain an edge such that our winners outperform the losers over the long haul. The rewards can be spectacular, but the losses can definitely dent your portfolio. It can be an adrenaline rush at times, and also very frustrating, as you might imagine.
In working with earnings trades over the years, we’ve found a safer, and somewhat calmer, way to play earnings: waiting until after the report. In other words, letting the sudden post-earnings move happen, and then jumping on board in cases where we feel the market has overreacted to the report.
When playing the post-earnings move, we generally like to go counter to the initial reaction.
If earnings and the outlook were good and the stock drops sharply, we’ll look to play a bounce with call options.
The pre-earnings optimism and “froth” has blown off the stock, and now the fundamentals and technicals can come back into play.
It works the other way as well — buying put options on stocks we feel the market has come down on too harshly after earnings — although not as frequently from our experience.
What do we look for when making these trades?
Pullbacks to areas of strong technical support (usually a moving average) after an earnings beat and/or positive guidance. The market often hammers these stocks because of just one missing piece of the puzzle, say the upside revenue guidance doesn’t quite meet the Street’s expectations. If everything else lines up, the company should be in good shape moving forward, and the stock should use the technical support as a foundation for the next leg up. That’s when we’ll jump in with a short-term call option.
A great example of this strategy is our recent call play on Express Scripts (ESRX).
The pharmacy benefit management provider beat the consensus earnings forecast and boosted its 2009 outlook after the close on Oct. 28. The stock had fallen heading into the report and was hitting its 50-day moving average, a trendline that had supported several pullbacks going back to April.
The chart below shows that ESRX rebounded strongly off the 50-day moving average following the report. The initial reaction after earnings was sluggish, which we felt was way off base for a stock that was in a huge uptrend and for a company that had just delivered solid numbers. We recommended a November call to our Winning Edge subscribers, who banked a profit of 100% on half the trade just three days later. We closed the second half of the trade a shortly thereafter for 157%. Not bad for being open for just two-and-a-half weeks.
What about more recent earnings plays?
Well, look at Salesforce.com (CRM), which reported solid numbers after Tuesday’s close. The shares pulled back sharply to their 20-day moving average and are now rebounding higher.
Or how about Home Depot (HD)? It beat earnings by five cents and issued upside guidance on Tuesday. But the outlook wasn’t quite up to snuff (according to analysts) and the stock dropped nearly 5% that day at its low. But that brought the shares close to their 20-day moving average. Wednesday, HD traded more than 3% above Tuesday’s low.
Earnings plays aren’t just about deciphering what a stock will do after earnings. Sometimes it’s best to get earnings out of the way, and then jump aboard after the market overreacts to a small tidbit of news.
More often than not, the stock price will rebound once the market figures out that it may have treated the shares a tad too harshly.
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