by Traders Reserve | September 17, 2012 8:00 am
I recently concluded my Earnings Player trading game for the second quarter with a Stone-Cold Lock of the Week option trade that doubled in value in less than 24 hours.
For those not familiar with the Earnings Player game, let me elaborate. Over the course of each and every quarterly earnings season, I provide weekly subscribers with option trades designed to profit from the wild swings in stock price that can come when companies report earnings results.
The trades are implemented immediately prior to a company reporting results and then closed the trading day after results are released. The cream of the crop of these picks I call my Stone-Cold Lock of the Week, one pick each and every week that Earnings Players won’t want to miss.
This past season, the returns for my Stone-Cold Lock of the Week were stellar. Of the seven Stone-Cold Locks, three of them doubled in value and two produced 50% returns. There was one breakeven trade and one small loser — down 15%. Risk $1,000 per trade and you would have pocketed nearly $4,000 in just seven weeks of trading.
Instead of twisting in the stock market wind, Earnings Players can generate huge supplemental trading income by simply taking advantage of market pricing after an earnings announcement.
Whatever your view is on the markets, being an Earnings Player simply makes sense.
So how did I find so many big winners for my Stone-Cold Lock of the Week? You might be remarkably surprised at how simple it can be. In fact, it is so simple anyone can do it. I’ll show you a few of my tricks by sharing with you how I went about finding my last Stone-Cold Lock of the Week, Pandora Media (NYSE:P).
In hindsight, buying a call option before Pandora released its earnings looks like a no-brainer. The biggest winners always look easy, but the truth is that there were plenty of folks betting against Pandora, making an earnings trade a difficult call.
With my approach, I remove all of the clutter and focus on a handful of simple facts. The more facts I have on either the long or the short side ultimately dictates how I play the event.
Here is a closer look at the 5 secrets behind my Pandora recommendation:
When playing the Earnings Player game, there is a wide universe of stocks reporting results each and every week of earnings season. We need to pare down the list to only those names that are seeing action in the market. We start our analysis completely agnostic. What I’m looking for is a stock with highly opinionated participants who back up those opinions with action.
Remember, for Earnings Player trades I’m looking for the home run. I want to see a stock move at least 5% up or down. Preferably I want a stock that can move double digits after news is released. Such moves pretty much guarantee huge gains on underlying options owned by Earnings Players.
In the case of Pandora, I knew right away, that I found a candidate for an Earnings Player trade. The online media company was a bit of a lightning rod of a stock with a very large short interest. Whatever the results of its earnings report, there was no doubt this stock would move in a big way.
While using fundamental analysis to guide my way for an Earnings Player trade may sound silly, it is the starting point of figuring out how to play a stock set to report earnings. Once I find a stock that I know will move, I need to figure out what direction that move will be.
Using fundamentals makes sense in that the market is inefficient in general in pricing stocks. When a company reports earnings, the market is presented with facts that can be used to better price a stock. Even if only temporary, the trading immediately following earnings is true and pure. Thus, get the fundamentals right and one will greatly improve the odds of a successful Earnings Player trade.
So, what fundamentals am I looking at? For the Earnings Player game I look only at earnings multiples and earnings growth rate estimates. If I find a stock that is trading for a low valuation and is expected to grow profits at a rate above the price-earnings multiple I will take a closer look at the pick for a long call option trade. The same is true if the opposite applies in the case of a short put option trade.
With Pandora, the stock traded for less than 10 times a hypothetical $1 a share in earnings. How reasonable is it to assume that Pandora will earn a buck a share? For a fast-growing company that proved its model can generate a profit, I thought the assumption was quite reasonable. Really, the stock looked too cheap to resist from a fundamental perspective.
There are many trends to follow when examining a stock about to report earnings. There is the trend of how the company reports against earnings estimates previously. There is the trend of how the stock is trading over the last year or how the stock traded after recent earnings reports. There is the trend of how the industry is faring during the current earnings reporting season. The list of places to look for trends goes on and on. I try to keep it simply by looking at the trends that matter most. One of the most obvious trends to look at is performance against the estimate in previous quarters.
If a company has proven it can beat the number on a regular basis, the odds of it continuing to do so is quite high. The attraction becomes more compelling on the long side if the market is lowering the price of shares in anticipation of some expected economic slowdown as was the case during the late spring early summer selloff in stocks. Because the market is quite poor in predicting the exact timing of an economic decline, earnings reports that beat estimates will often result in a shock to the price of a stock to the upside.
In the case of Pandora the company being a fairly new company to trade publicly had little track record to speak of with respect to earnings beating estimates. What it did have was its most recent quarter that showed the company had beaten estimates by a wide margin. Operating close to breakeven, a significant beat of the number is quite meaningful. Despite that strong operating performance the market was trading Pandora lower.
The Cuban Missile Crisis, for those history buffs, provided a textbook example of group think. A common dilemma for governments, corporations or stock markets, group think can paralyze. It can also result in profit opportunities in the case of the stock market.
So many times the macro environment can take the entire market in one direction or another. At certain times, usually when emotions run highest, pricing can get entirely out of whack on individual names being carried out to sea by the wave. At those moments valuations or future prospects matter little.
Earnings can change that dynamic in a major way. For whatever brief amount of time, the market will attempt to rescue these out-to-sea stocks if earnings results merit such a move. It may only be fleeting, but that’s why Earnings Player trades are over and done with in less than a day of trading. We are simply looking for that slap in the face moment that can result in big price moves for stocks and the underlying options that Earnings Players trade.
For Pandora, its shares were lower thanks mostly to the cold reception of Facebook. The social networking site seemingly lost value every day since going public. The stark action spooked investors in other IPO stocks – especially those tied to the internet. Forget about potential, the assumption was failure – guilty until proven innocent.
The proof of innocence was likely to come in the form of earnings. A strong report by Pandora and a huge move higher would be the result. Sure enough, the company delivered and shares zoomed higher by 20%. That’s how you make a Stone-Cold Lock of the Week.
One of the biggest problems for investors and traders alike is pulling the trigger. They can analyze and over analyze, but if they don’t execute they will always lose. In order to play the Earnings Trading game, players must make conclusions from their analysis and trade.
I like to call it making an educated guess. As I said previously, if the preponderance of the evidence suggests a certain outcome, go with it. One can never know for certain how a trade will work out, but if you do the work consistently and keep playing win or lose, you will ultimately profit.
In analyzing the Pandora selection it would have been easy to miss the opportunity standing on the sidelines. The company is facing a ton of competition and there were so many shorts betting against the company one could easily get cold feet on this trade, even with a large number of facts suggesting this would be a blowout quarter and a huge Earnings Player trade.
You have to make the trade. It’s as simple as that.
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