That special time of year is finally upon us!
No, it’s not the summer solstice…
Or Flag Day, that was last month.
Or even “World UFO Day”, which apparently comes around every July 2nd.
Get excited – because it’s even better than all those combined:
It’s officially earnings season again!
As you probably already know, each quarter is marked by the release of earnings reports – where U.S. companies announce their latest earnings and sales results.
Many times, the info included in the report is in line with company expectations. Investors shrug, the market yawns, and everything continues along like it did before – business as usual.
However, sometimes a company will uncork a huge earnings surprise, meaning that the Earnings Per Share (EPS) is way off the consensus EPS forecast. The difference between the two is measured as the percent surprise.
When a company’s earnings are way off from what was expected, investors will sometimes go into a frenzy – creating huge gaps in price at the following market open.
For some companies, a positive surprise (meaning earnings exceeded expectations) will result in a jump upwards, while a negative surprise (earnings fell short of expectations) will cause the stock to slump considerably. Or sometimes, it won’t even matter, and the stock will fly off the handle with seemingly no rhyme or reason.
But for other companies, even big earnings surprises will barely tip the scales at all. The effect of an earnings report on a corporation’s stock depends on the company itself, as results can (and do) vary.
And some stocks just love to jump around after an earnings report, regardless of what the earnings actually are.
Take Herman Miller (NASDAQ: MLHR) for example, which released an earnings report back on March 21st this year. Despite outperforming the consensus EPS forecast, MLHR dropped more than 10% over the next day of trading:
They beat their expected earnings and STILL got hammered by investors.
There’s obviously more to it than just measuring earnings per share, though. The guidance is arguably the most important component of an earnings report, as it gives management a chance to explain why the earnings are the way they are, and where the company is heading.
But even then, it’s extremely hard to tell which way a stock is going to go pre-earnings. Unless you have insider information (which is illegal, by the way) or a crystal ball (which don’t exist as far as I know), trying to trade an earnings report with naked calls or puts isn’t investing – it’s gambling.
So instead of tearing your hair out, trying to figure out which way a company is headed during earnings season, you can just identify companies that tend to “pop” following an earnings report.
Because there are two options trading strategies – the straddle and the strangle – that allow you to actually profit off of a stock’s movement, as long as it moves enough, regardless of direction. Both strategies are only profitable when the price of a stock moves a significant amount (either up or down), so the important thing to focus on is finding stocks that really move after earnings.
Let’s look at Herman Miller again, which actually released another earnings report this week on July 2nd. We saw that last time, it plummeted over 10% in just one day. It’s done so for the last few earnings reports as well, so it looks like Herman Miller is one that tends to “pop”. Let’s see what happened the day after earnings were posted, July 3rd:
Once again, Herman Miller beat the expected earnings, posting a 11.86% (positive) surprise percentage. This time, the stock skyrocketed, “popping” up over 10% in just one day.
If you would have researched MLHR’s past performance post-earnings, you would have known that this stock tended to jump following earnings reports. With that information, you could have used an options straddle or strangle to capture some easily attainable profits.
But finding desirable stocks to trade is half the battle. What you also need to know is when to enter trades, and what strategies to use.
When to Enter Earnings Plays
Because an option’s premium will rise significantly in anticipation of an upcoming earnings report, traders can get a better deal on them by entering positions two to six weeks prior to the earnings report. Your funds will be locked up in the options until earnings are announced, but it’s the trade-off you make to avoid the extremely high premiums that build up in the days before an earnings report. This is due to the potential for increased volatility once earnings are announced.
So once you’ve picked a stock that has an earnings report in two to six weeks, you then need to decide which strategy you’ll use – a straddle or a strangle. Both strategies enjoy unlimited upside with limited risk and are different avenues that allow you to achieve the same goal.
Strategy 1: The Long Straddle
This options trading strategy involves buying a call option and a put option with the same strike price and expiration month. In addition, the strike price of the options must be at-the-money. So, when you select your options, try to pick ones with strike prices closest to the price of the underlying security. For example, if the price of the underlying stock was $34, you’d want to pick the 35 strike price call and put.
As long as the stock “pops” enough following an earnings report, this strategy will put you in a profitable position.
Strategy 2: The Long Strangle
The long strangle has the same goal as the long straddle, which is to profit off a stock’s volatile movement in either direction – but it works slightly differently.
Instead of buying options at the same strike price, a strangle involves buying an out-of-the-money call and put, at strike prices that are near (but not at) the underlying security’s price.
For example, if an underlying stock was trading at $30, and the two closest strike prices (that aren’t 30) are 25 and 35, you would buy a 25 strike price put and a 35 strike price call.
So, let’s say you’ve bought a long straddle a few weeks in advance of an earnings report, the stock “pops” like you wanted it to, and now you’re in a profitable position – the question many traders then ask is:
“What the heck am I supposed to do from here”
Sadly, unlike playing earnings reports via options trading strategies, responsibly trading a stock post-earnings is a bit more complicated, and requires a sound trading method – something that we offer to our students throughout our many training courses.
While knowing how to play earnings won’t make you an overnight millionaire, it does give you a tool that allows you to find the low-hanging fruit when earnings season rolls around every quarter. Who knows, maybe another great earnings play is coming up soon… I’d better go check.