Stock earnings are usually a volatile time, and there is a lot of opportunities if you are on the right side of the move! Earnings are often considered a gamble, they are an uncertain event that is based on analyst expectations. Will a company beat the overall analyst expectations of their quarterly earnings or not? When trading earnings with options is to determine what direction you think the stock could go. Options trading earnings strategy can be lucrative for traders if they understand the nuances of options behavior.
A company’s earnings are after-tax net income or profits in a quarter or complete fiscal year. They are used to determine a company’s intrinsic stock price and their projected profitability.
There are three main components of a company’s earnings analysis:
- Earnings per share
- Revenue
- Forward guidance
Based on these components, the price of stock either fluctuates higher or lower depending on a stock either beating or missing analyst expectations. However, it’s never that simple. First, let’s talk about each component individually before breaking down the full strategy.
Earnings Per Share
A company’s earnings per share (EPS) is a company’s net profit divided by its common shares outstanding. This shows investors, analysts, traders, and whoever cares how much money a company makes for each share of common stock it has. EPS is an estimate of corporate value. Typically, the higher the earnings per share the more profitable the company is.
When it comes to earnings announcements and trading these reports looking at the numbers and saying “beat” or “miss” will not give you a clear picture. Earnings reports also come out either before the bell or after the bell. In this scenario, it won’t be possible to trade options throughout the report. If you wanted to you would have to have a broker that permits after market hours trading.
There are two analyst expectation possibilities. Positive earnings or negative earnings. Yes, that is right, a company can lose money… Typically a miss in earnings will weigh down on a company and should go down, however, we have to consider the other factors. The point is if you guess that earnings will beat and you buy the stock or option that won’t guarantee the stock will go up.
Take a look at the example below, we had a quarter where we have Tesla (TSLA) reporting a loss or a negative earnings quarter. However, you can see that did not stop the stock from hitting an all-time high. Tesla has been a stock that has just recently started reporting positive earnings quarters however the stock has been posting highs!
Revenue
Revenue is the next, and what seems like a less important number to dictate the direction of a stocks move from the earnings report. The revenue in a quarter is how much money has come in. This is before expenses, taxes, etc throughout the quarter. The important aspect is the growth in this scenario. It’s quarter over quarter growth that people typically watch. However not too many consider this an important factor because revenue does not reflect profitability. You can have a company with over $10 billion in revenue but their expenses are $12 billion. However, that would not be reflected in the report.
Forward Earnings Guidance
This may be the most important aspect of using an earnings report to develop a trading idea! It’s the most important aspect for the most immediate direction of the stock. This portion of the report is the information given about the company’s future. Typically talked about by management, we highlight future expectations and forward-looking statements. They highlight the company’s future sales and earnings based on their industry and also the macro trends. This allows traders and investors to evaluate the company’s potential for future profit. In some cases company’s can beat earnings but have poor forward guidance. Which was the case for a lot of companies during the 4th quarter earnings season. For example, Apple, Facebook, and tech
The real earnings strategy
This earnings strategy is actually a pent up continuation move AFTER earnings! So it’s technically not a play on earnings. However, it’s great to know after earnings pass so you can find the continuation move.
The strategy starts off with identifying a stock that has just popped aggressively from earnings. We want to see either a gap higher or an extended move with a strong bullish candle. Then begins the waiting game!
Let’s use Cisco (CSCO) as an example. In the image below you can see that we had earnings on the company and we experienced a pop (gap higher).
From here, we want to identify a pullback and the creation of a bull flag. This is a consolidation in the form of a range or a pennant around the area that price gapped too.
Bull Flag example:
Bull flags are great breakout trades. This is at the end of an extended move or a gap move. They can be used otherwise as well, not just in earnings. There are three general styles of bull flags that you will see in the market. Here they are all laid out!
That means the next to this strategy is waiting for a bull flag to form after such an extended push on the asset in question. Now, this could take days and sometimes longer. So you would want to find as many of these setups as possible waiting for them. Take a look at CSCO this is a chart on the daily. You could look at this and this is a primed bull flag waiting to break and that would be great! Based on this your “trigger” area for the long is above $42.70. This is a break out strategy.
On the other hand, it’s always important to look at the 1 or 4-hour chart when you are identifying trades like this. Below is a 1-hour chart of the same stock in the same period you could have identified a break out period through the $41.50 level where we have the lower highs of the bull flag triangle.
The next step is the options play behind it. Preferably long calls. You are looking for at least 2-weeks of time value. So an option that expires in 2-weeks or greater. Keeping in mind that the longer the options expire, the more you will have to pay for them.
Risk Management
When it comes to risk management in the options market, it’s hard to base the risk tolerance off the underlying because there are other factors that are attributed to the greeks. Which could decay the value of the premium faster or slower than the underlying movement. It’s not as linear as purchasing common shares.
You could say you want to cut your losses under $40.50 but if the price stays the same then the value of the options position will drop fast. So you could be down 90% of the option’s value when the price is still at $41.75.
Meaning you should base your targets and stops on percentages of the premium paid for the full position. Typically on swing trades, depending on how long you are planning to hold the trade, you would want to risk about 40% of the premium. Your first target would be the prior resistance point. Or 50% of the premium gain in the options contract. Then you could let the rest run.
Always use an options calculator. This allows you to see the potential profit and loss of the position based on time and the underlying movement.
In this case, you can see how well the position played out. We got the continued move, there are other criteria that play into this strategy, like the levels, volume, volume profile, and options order flow to help you out.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
