5 Keys to Trading Earnings With Options

by Traders Reserve | July 19, 2012 8:55 am

Are you a gambler? Do you crave the adrenaline rush that comes with rapid fire trading? Are you willing to take risks where others will not in hopes of breaking the bank with a huge profitable trade?

If you answered yes to any of these questions, trading earnings is for you!

There is simply no other dependable event that triggers the volatility necessary for a big score. When using call and put options with underlying stocks set to report earnings news, traders are poised for huge profits.

The gains can be spectacular, but so too can the losses. The trick is to have a game plan and to stick with that plan throughout the entirety of earnings season. Without that plan you will truly be just a gambler.

Fortunately there is a game plan that you can follow to easily and profitably trade earnings. I call them the five keys to trading earnings and I’ve used these keys to make successful earnings trades for nearly two years now.

That track record is nice, but the future is just as bright. From the dawn of the stock market, irrational investors have always missed the mark when pricing stocks. When a company reports earnings, the market has a chance to react to the news and for a brief moment get the pricing right.

That correction happens immediately in the trading session after an earnings report is issued. The volatility is what helps propel our option trades on underlying stocks of companies releasing the news higher.

Gains can range as high as 1,000% in certain instances. The losses are capped at 100%. In isolation a losing earnings trade might be painful, but in the grand scheme of things such losses are acceptable.

Stay true to the approach and you will do just fine trading stocks of companies announcing earnings.

Here are five keys to trading earnings:

1) Current Stock Price

It may be surprising, but the current stock price of a company about to report earnings can provide traders clues with respect to future action. Has the stock been running up in advance of the report? Where is the stock trading versus the rest of the market? Has the company released guidance in advance of the earnings report? What other news out there is affecting current stock price?

The answer to these questions will give you clues as to the future. For example if a stock is trading flat when the rest of the market is rising, there is potential for big gains when earnings are released. Investors tend to get nervous in advance of earnings. The concern is a stock losing value on a bad report. If the report is strong, the reaction to the upside is powerful in that traders are making up lost ground while they waited for the report to be released.

The current stock price is the first step in being an earnings player.

2) Short-term technical factors

Nothing fancy here. Traders can get a sense for where stocks are heading by simply looking at the 200-day moving average. Knowing the top and bottom of a stock’s trading range helps determine the extent of an opportunity when earnings are released. A stock at the bottom of its range has the potential to move significantly higher on a positive report. Another technical factor to look at is the one-year and 3-month trading charts. What patterns if any are discernable to traders?

Personally, I prefer the head and shoulders pattern. If I see the reverse head and shoulders setting up in advance of an earnings report, I move the stock to the top of the list of potential trades. Many traders loathe earnings season. Action in the wake of an earnings report often contradicts long-standing trading factors. I take the opposite view. If I can get a sense of direction in advance of the report by using some simple guidelines, I am ahead of the game.

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.

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