The reason traders just can't use news to beat the market is because the market already knows about it. You might think that buying a stock ahead of what analysts call a very strong and promising earnings report is a good idea, but so do thousands of other traders. That means it's already priced into the stock.
And it doesn't matter what the earnings end up being. If everyone thinks they will be good, they will buy stocks or options ahead of the news.
Either the bulk of the move happens before the earnings announcement or, heaven forbid, the company misses its expectations. In both cases, the result is usually not pretty.
Fortunately, you can profit from others who are chasing a quick buck based on news reports or expected earnings.
Money Morning's options trading specialist, Tom Gentile, reasons that even if you're right and the stock goes up, the options contract might have been so expensive that your gains are limited.
Tom says trying to plan an options trade around an earnings call could backfire. Instead, he has a better plan based on historical patterns around earnings.
Here are the three factors you need to know to build a successful trade during earnings season.
And the best part is you don't need to worry about how good or bad an earnings call goes...
Profiting from Earnings Patterns of the Past
Tom looks at three factors surrounding earnings for each stock he wants to trade. And if there is a pattern - any degree of consistency - with how the stock, the options, and the company behave around the earnings announcement, then he can trade accordingly.
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Here they are:
- What did the price of the stock do before and after earnings?
- What did the price of the options do before and after earnings?
- Does the company beat or miss its earnings estimates a lot?
For example, take a stock where the share price tends to rise before earnings, the price of the options tends to rise ahead of earnings, and the company tends to beat analyst estimates. We can build a strategy around that to make money, and we don't need to pay for an overpriced contract or hope the company's earnings call is a hit.
Rather, if we know that the price of the stock moves up into earnings and the price of the option moves up before earnings, then we can buy ahead of the report and get out just before it is released.
In other words, we're selling before the earnings call to profit from historical patterns instead of hoping the call will go our way.
It is the perfect strategy with high odds of making some big money. Tom's found options that have surged 80%, 100%, and even over 500% during the run-up to earnings season.
And he's got another stock that landed on his radar...
This Stock Fits the Earnings Season Trade Strategy
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Of course, we can apply the same principles to stocks that tend to go down ahead of earnings and buy put options on them. Tom's system found data storage device maker Western Digital Corp. (NASDAQ: WDC), which tends to drop just prior to its earnings report. The company tends to either meet or miss expectations, and it doesn't often beat expectations. That means traders buy puts ahead of earnings hoping to cash in after another miss.
Instead of paying a steep price of these puts and hoping the stock plunges after a bad earnings call, we're going to try to buy the puts a little early and sell them at an inflated price before the call.
Western Digital is expected to report its earnings after the market closes on Wednesday, July 31. That means we would only be in this trade - owning puts - for about a week, because we would sell them the day before or the day of the report.
Just one more point: We want to buy at-the-money options, whether they are calls for a bullish play or puts for a bearish play. These are options that have strike prices close to the actual price of the stock. We do this because at-the-money options are highly correlated with the movements of the underlying stock, and that supercharges the percentage return we can achieve.
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