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How I Trade Earnings Announcements!

Posted by Pete Stolcers on July 3, 2006

In today’s option trading blog I will discuss earnings announcements. Traders are paid to predict the future. When they perform well, they are rewarded. When they perform poorly, they find new work. Earnings carry uncertainty and a diminished ability to predict.

Playing the actual earnings announcement is pure gambling. I have seen stocks with great earnings get smashed after they exceeded estimates. I have also seen stocks that looked like they were going bankrupt, rally after another losing quarter. Sometimes stocks do the expected, sometimes they don’t. After years of trying to model an earnings trading system, I have found the event too random.

On the other hand, once earnings have been announced, I scour the market for stocks that have outperformed and have raised guidance. I analyze corporate comments to determine why business is so good. Stocks with one time extraordinary items are cast aside. I seek stocks where the conditions will be intact for at least six months. A buying opportunity will present itself once the excitement of the release subsides. Earnings provide a brief glimpse into the future. The same is true (from a shorting perspective) for stocks that have disappointed and lowered guidance.

These surprises create a gap and the stocks are instantly on my radar. The actual gap might present an opportunity, but the stock usually attracts too much attention. If I get in at a good price right out of the gate, I will often hold a partial position overnight if the stock closes on the high. The problem with day trading is you have to be nimble. The news has attracted momentum players and at any moment, the move can reverse. The better trade will come after the news has been defused.

A few days after the news has hit, the trading activity settles-in. This is when I can determine if it has any fuel left in the tank. The bigger the initial move, the greater the chance for a small short-lived reversal. I know this because the day traders need to be shaken out – they have no conviction to the stock, they were just looking for a quick buck. Once that reversal fades, you will have a nice entry point for the next leg up. If the first move created a breakout, I watch for the reversal that tests that level (now support). If it holds, I have a nice entry point.

The exact opposite holds true for stocks with negative news. Often you will see a stock with a current quarter that beats estimates – get spanked. They have lowered future guidance. To a degree, I feel the market factors in the chance for better earnings. That anomaly may have resulted from Sarbanes-Oxley where corporate executives want to underestimate/over-deliver. Regardless, the market discounts the future and places a premium on that part of the news. This is one reason why “misses” are dealt with severely.

My favorite set-up happens when a hot news item is suppressed by a weak market. The stock wants to rally, but a weak market keeps a lid on it. As soon as the market regains its footing, the stock takes off. Watch for these situations and monitor the stock on an intraday basis relative to the SPY. A chart that overlays both will reveal any relative strength.

As earnings season approaches, I am looking in the rear view for what has been announced. That is where I can find certainty and where I have the best chance of predicting future price movements.

Two final notes. I do trade pre-earnings patterns, however, those trades are closed before the announcement. That set-up will have to be covered in another article. Secondly, I may have longer-term positions that I will carry into earnings. They are by nature intended to “weather” theses events. I like the position and I’m confident that long-term I’m on the right side of the trade.

If you have an announcement that you think presents an opportunity, post a comment and tell me why you think so. I will try to respond with an approach.

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Posted in How I Trade Options!

Option Trading Comments

  • On 07/04, Bill Roberts said:

    I was curious, do you ever trade strangles/straddles around an earnings announcement?  I have had success with them if enterered 3-4 weeks before the announcement, and volatility is still relatively low, thus enabling decent prices. The stock MUST move to be profitable though...<br><br>Thank you.

  • On 07/05, Pete Stolcers said:

    Hi Bill,<br><br>The strategy you use is employed by Specialists/Market Makers. They try to buy the premium when it is relatively cheap and as the earnings date approaches they try to unwind the position and take the gains as the IV’s rise. There exists a potential bonus. The recent disclosure requirements force company’s to pre-announce material deviations and there is a chance for a big winner.<br><br>I have tried your approach and have found that you have to be willing to take many small losers to hit a big trade. I have also found that it is more effective when the VIX is realatively low. While the strategy may work, I have found my method in the article to be more effective. <br><br>I am a directional trader. I look for situations where I can get on one side of a trade. Straddles/strangles are neutral strategies and they comprise less than 2% of my trading activity.

  • On 08/28, eric alexander said:

    as a relative neophyte, i was surpised to learn how much instituitional investment plays a role in the markets. so then i began to wonder what drives instituitional investments?  other than inflation numbers, it seems earnings play a pivotal role in their decision making.  i was wondering if you were familiar with pitbullinvestor’s earnings trader? it’s based around preannouncements; any comments?

  • On 08/28, Pete Stolcers said:

    I’m not familiar with their record or method. I can only comment that holding over the anouncement is a very difficult proposition. Sometimes the number is great and the market hates it, sometimes the number is bad and the market likes it. The implied volatilities of the options are "juiced" so if a move happens it has to be big to work out. As to your other point, earnings are the key to most stock movement and the statements and guidance that the company gives are extremely important.

  • On 07/15, Lawrence Quan said:

    When is the best time to enter a trade on earnings and what option would one buy?  Is it best to enter the trade weeks before, a few days before or the day before the announcement.  Should one buy one, two, or three strikes out of the money?

  • On 07/16, Pete Stolcers said:

    Hi Lawrence,

    I could writea book on this topic. There are times (like now) when it is possible to play the actual earnings.  You need a very strong market that has momentum. When the earnings are released, the stock rockets higher even on a small “beat”. You have to make sure that the stock has not run up too much before the release or there is a good chance the good news is already expected. Know that the option premiums will be inflated because there is uncertainty surrounding the stock. If the number comes out and the stock stays flat - you will lose money. The option implied volatilities will collapse because the uncertainty is gone. In other words, you don’t just have to be right, you have to make sure a huge move results. If I am playing a release, I need to evaluate the duration and magnitude of the move. For a nice gradual extension of the current rally, I will choose a back month in the money option on a stock that is grinding higher. In a high-risk, explosive move, I will stay with a fronth month out of the money option to limit my risk. The safe play is to buy the options 1-2 weeks before the earnings release. Optimists will already start accumulating the stock. The implied volatilities will also hold their value and perhaps even increase. Just before the number, you exit the poistion and take your profits. If you have enough of a profit built in, you might want to leave a few contracts on if you still feel the chances for a big surprise loom. Remember, that normally playing earnings is very unpredictable. A strong market increases your chances for success. You need to find an edge and I always suggest looking back to see what the stock has done after prior announcements.

  • On 08/11, John Arokiaraj said:

    I always feel trading is a tough subject to understand. But I was always wanted to get to know about it. Thanks for this post. I had fun on reading this.
    http://www.atlanticcity.com

  • On 05/09, Lingzi330 said:

    Hi Pete, I love your education articles here. One question. As for trading before the earnings. some people recommend to trade straddle or strangle couple days before the earnings, how do they do it? do you think it is a good idea to do that or it is very risky. Thanks

  • On 05/11, Pete Stolcers said:

    I am not a big fan of earnings plays. Holding over the number is too much of a crap shoot. I do like to trade before and after the number.

    Buying stradles or strangles is a tough way to make money because the option premiums are inflated before the release. The risk is elevated and there is uncertainty priced into the options. Once the number is out, the premiums collapse. You need a VERY big move to make money at this.

  • On 08/19, Michael Perrone said:

    The best way to play strangles and straddles is to look for a great deal on implied volatility. Sometimes it’s just a matter of looking beyond the front month. After the catalyst your loss in implied vol is much less if you find a good deal going in, and you have more time to sell back as well. One thing is for sure, it’s nuanced tricky business to play earnings successfully.

  • On 09/23, Willie said:

    Pete,

    very interesting way of trading options,
    Do you have a particular web-site where you can get the pre-anouncement of better than expected earnings?
    I realy enjoy your article., thanks

  • On 09/23, Pete Stolcers said:

    Sometimes companies pre-aanounce earnings, but that news is instantly factored into the stock price before it even opens.

    Otherwise, no one knows if the earnings will beat expectations. That would be insider trading. The are sites that publish “whisper numbers” but that might also be factored into the stock price ahead of the release.

    www.earningswhisper.com is a good resource for this information.

  • On 11/16, Ario said:

    Hi Pete -

    Great article! I am learning to do this right now. Quick question: when you are doing this earning trades, do you buy the In-The-Money, Out-The-Money, or At-The-Money calls/puts? And as you said, the stock that has big gap usually has more fuel left in tank for 2nd rally, how long you usually buy your option for (1 month, 2 months to expiration?)

    Thanks,

    Ario

  • On 11/23, Pete Stolcers said:

    I like to find stocks that are in a long term trend that is orderly (not choppy). If the stock breaks out to a new high and the market is strong, I will buy in the money calls and I place my stop at the breakout level. It can test that level, but it can not breach it. If the market is not rallying and it is not trending, I tend to sell out of the money put spreads. The earnings have been good, the stock should have buyers and I want to take advantage of a volatility decline after the news and time decay. Sell thge put spread below that support.

    There are instances where the stock is close to breaking out after earnings. I will place a conditional order to get in if the stock breaksout.

    Use same line of thought for bearish positions.

    The most important thing to keep in mind is not to hold over the earnings announcement. That is a crap shoot.

  • On 02/13, JayRay said:

    Do you have a strategy for trading pre-earnings announcements?  Where you would enter an option trade 2 to 3 weeks before earnings date and close the trade on or before that date?  Thank you.  JayRay

  • On 02/14, Pete Stolcers said:

    I am back testing many different systems and I plan to offer earnings plays in the future.

    As you point out, the key is to get out before the number.

  • On 06/11, Pdaguy said:

    Looking at COOL.  I believe I’m seeing relative strength here with this company.  It has been very strong (reaching a new high) in a weak market.  Earnings to come this Monday and I believe they will blow out.

    Looking at the July 5 calls @ $.40

    My problem is that I never really know what option to buy for the most leverage.  Do I buy the July or some other month?  In the money or out?

  • On 06/13, Pete Stolcers said:

    Your opinion of the magnitude and duration of the move will always determine the best strike/month. If you are looking for a short term explosive move, front month out of the money options always have the most potential for huge % returns. If you are right, you can make 1000%. If you are wrong, you will lose all of your money. If you can even hit one out of five of them, you will make money. These plays should be a small part of your overall strategy.

  • On 06/29, Dana Franz said:

    Hi-
    Just reading through your thread here, very interesting. I wanted to ask about your statement that, “The most important thing to keep in mind is not to hold over the earnings announcement. That is a crap shoot.” Does this mean you sell any stock you own for which there is an approaching earnings announcement?

    For example, I’m holding a significant position in EGHT right now. Very volatile, but I’ve made a lot (bought in around $2.20, currently trading around $4.50). Their fundamentals appear to be very strong. They have an earnings announcement coming up on July 20. Would you advocate finding a good exit prior to that announcement, and then deciding whether to get back in after the announcement?

  • On 06/29, Pete said:

    It is important to distinguish between investing and trading. My point is not to buy calls on a stock that is releasing earnings the next day because you think it is going to rally. That is a crap shoot.

    If this is a long term investment, hang on to it. It is always wise to buy a few puts or sell some calls to hedge the position a little, but you don’t have to get out if itsince it is a long term investment.

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