Earning Season Means Its All About The P’s And E’s: Part II
Dragonfly Capital | Apr 15, 2015 07:39AM ET
Alcoa (NYSE:AA) officially kicked off earnings season for most people last week. The big action started yesterday though as the big banks started to report. The season will run for another 3 weeks or so, or at least that is what the headlines will tell you.
In fact there are companies that report their earnings nearly everyday. Not just the four weeks after Alcoa. If you are an active trader or portfolio manager you already know this. I take an in depth look at at least 2 names every day. And when I look at the calendar to see who is reporting it all boils down to the P’s and E’s.
Those of you that know me just did a double take. Yes I have a CFA designation, but I really do not use it for trading. But I do look at the P’s and E’s. Only that does not stand for Price and Earnings. Instead it stands for the two types of activity to pursue around an earnings report: Protecting, or Exploiting. Yesterday I tackled Protecting, now lets look at Exploiting.
Exploiting
When a company reports earnings it can move the stock price significantly. Some stocks move as much as 20% or more, even for big companies. And sometimes it does not matter if the company beats, misses or meets expectations. What market participants expected (not Wall Street analysts) can move a stock as much or more so than the actual report for the quarter.
And it can be counter intuitive as well. For example Intel (NASDAQ:INTC) reported earnings Tuesday after the close. It reported earnings and revenue in line with expectations, and then guided lower than expectations going forward. And how did the stock respond after hours? It went up more than 1%. The result of this is that no matter what a company reports, there is an opportunity to make money off of a move in the stock price after the report.
There are two sets of tools to do this: the stock and options. Using the stock you can either buy or sell the stock short ahead of the report. If you are right about the direction the stock will move, then you win. But if you are wrong and the stock moves against you it can be expensive. If ever participating in the stock market could be described as gambling, buying or selling a stock in anticipation of an earnings move is it. Do not do it. If you want to own a stock for other reasons that is fine. See the Protection article on how to manage that.
Options are the only way to Exploit the volatility that happens around earnings in a safe, defined risk manner. And even then you can lose all of your money. The key is to use all the tools available to you create the best possible probability for a winning trade. Understanding the technical and fundamental set up for the company goes a long way. But there is added data from the options flow.
Get The News You Want
The first piece of information is what the options market measures as a potential move post earnings. For a stock that is reporting earnings very close to options expiration this is a simple calculation. The at the money straddle gives the market perception of the potential range of stock price reaction. If the straddle (at the money put plus at the money call) can be sold for $2 then the market expects the stock could move $2, in either direction.
With a little data digging, you can get an estimate of whether this estimate from the options market seems rich or cheap. Just look at how much the stock has moved on average over the each of the prior reports. If the historical move is only $1 then the $2 estimate might be over estimating, without any other information.
Armed with these data points and the fundamental and technical set up you can then use your tools (options) to create a trade opportunity to maximize your chance of success with minimal capital at risk. How? This is how I looked at Intel ahead of the report:
Intel, traveled in a range between 29.65 and 35.50 since last June, with a break out higher that held held for 3 months. The movement since falling back into the range has been in a downward channel. Heading into earnings it is testing that downward channel and horizontal resistance at 32.10 with the RSI pushing over the mid line, into the bullish range, while the MACD is rising. There is support lower at 30.50 and 29.65 followed by a gap to fill to 27.80. There is resistance above at 32.10 and 32.60 before 33.20 and 34.75. The reaction to the last 6 earnings reports has been a move of about 2.93% on average or $0.95 making for an expected range of 30.75 to 32.80. The at-the money April Straddles suggest a larger $1.35 move by Expiry with Implied Volatility at 49% above the May at 25%. Short interest is moderate at 3%. Open interest is very large above at the 34 Strike and below at the 30 Strike, but sizable in between as well.
Trade Idea 1: Buy the April 32/33.5 Call Spread for 40 cents.
Trade Idea 2: Buy the April 32.5/33.5 1×2 Call Spread for $0.14.
Trade Idea 3: Buy the April 32/33.5/35 Call Butterfly for $0.30.
Trade Idea 4: Buy the April/May 34 Call Calendar (12 cents) and sell the April 30 Put (12 cent credit) for free.
#1, #2 and #3 give the short term upside, with #2 using margin. #4 gives the longer term upside and uses leverage to lower the cost. I prefer #3 or #4.
With the movement higher after hours, the Call Butterfly (#3) will likely be a small winner against risking only 30 cents, or less than 1% of the stock price. The Call Calendar shorting the 30 Puts will be a big winner. The two short pieces look as if they will expire, leaving a May 34 Call to sell or hold for more possible upside through time. This risked owning the stock at the bottom of range that held it since June, and outside of both the options expected and historical expected move. If the stock runs through 34 then the Calendar will move towards zero, making the trade break even.
Each situation presents different opportunities, but there are almost always was to use options to manage risk and give a high probability of a winning trade.
DISCLAIMER: The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
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