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5 Keys to Trading Earnings With Options

Taking advantage of market mispricing ahead of earnings

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3) Wall Street Estimates

Love it or hate it, much of how investors determine price in a market is based on how a company does versus Wall Street estimates. The beat-the-number game is loathed by many, but is a sure-fire way to trigger volatility in a stock. Bet on the right side of the number and a trader can make big bucks in a short amount of time.

One of the first things I examine when looking for an earnings predictor trade is changes in estimates during the quarter in question. What was the estimate at the beginning of the quarter? What is the estimate just prior to the earnings release?

Typically analysts are slow to change their estimates. If there has been any sort of news on a macro or micro level, traders can duly note such news. If the estimate has failed to move on the news, an opportunity is created.

Finally, the point in the economic cycle can often determine how a company does versus the estimates. At the beginning of a cycle, estimates are too pessimistic. Wall Street expects companies to prove it first. As a result, companies often beat estimates by a wide margin at the start of a new cycle.

Put it all together and traders can find lots of clues as to how a company will perform against estimates by examining these numbers.

4) Current valuation

Although a market may be inefficient, fundamentals ultimately rule the day. The way a stock fluctuates after releasing earnings is a reflection of a market attempting to be more efficient. If a stock trades for a low valuation in relation to earnings growth, investors eventually get the clue.

In looking for earnings predictor trades I look exclusively at valuation in terms of price to earnings. I use Wall Street estimates to get an idea of future growth potential and compare that to the current trading multiple. If a stock trades for a low valuation and is expected to grow by a large percentage, there is an opportunity for big trading gains when earnings are released.

Stocks with a high valuation need to jump over a higher bar. It is not entirely impossible, only more difficult. Use valuation as a guide to how the market should be trading your earnings predictor stock.

5) Performance against estimates

They say that the trend is your friend. I agree with that sentiment. If a company has a history of besting earnings estimates, there is a strong likelihood of a repeat performance. It is far more difficult to ascertain the future with a company that has mixed results against estimates.

The greatest opportunity can arise from a company that has beaten estimates by a wide margin. If you recall from our one of our other keys to finding earnings predictor stocks, Wall Street is reluctant to increase earnings estimates even if prior performance suggests doing so. When the proof in the pudding comes in the form of another earnings beat, the market reacts accordingly with a big bop.

This key is remarkably simple. The only risk is that sometimes trends end. When they do, a stock is likely to lose significant value. The protection is to know the point in the business cycle and to utilize strict selling discipline in order to protect a trade when it goes wrong.

Article printed from InvestorPlace Media,

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