The Dow took a hit Tuesday (April 18), dropping 100 points after Goldman Sachs Group Inc. (NYSE: GS) missed earnings expectations. Now, this came as a major surprise to analysts and Wall Street – but more importantly, to anyone sitting and waiting to take profits on a seemingly easy trading opportunity.
And that's exactly what I want to talk to you about…
The biggest threat to your portfolio during earnings is an unexpected result – like GS on Tuesday.
But the solution is actually quite simple.
How to Capture Unlimited Profits During Earnings Season
Typically, when companies make positive earnings announcements, it's considered to be good news. This propels more buying, and that demand drives the stock up in price. The same is true for the reverse – when companies make negative earnings announcements, it's typically deemed bad news. This causes a mass exodus of the stock and the price drops quite a bit.
Note that I used the word "typically" above…
While both situations are the most common outcomes for positive and negative earnings, there are cases where bad news isn't actually bad – and good news isn't actually good. Take Wells Fargo Co. (NYSE: WFC), for example. They beat expectations, coming in at an earnings per share (EPS) of $1.00 versus consensus estimates of $0.97 EPS – which you'd think is good news for the stock. But as I told the CNBC pundits last week, it's actually the number one bank stock to avoid right now because of its uncertain future due to the misconduct scandal.
So how exactly do you trade around earnings without facing the risk of a completely unexpected outcome?
Use a straddle.
A straddle is an options strategy you'd use to profit during earnings season and also during times of market volatility. It involves buying both an at-the-money (ATM) call and an ATM put with the same strike price and the same expiration. An option that's at-the-money simply means that the stock price and the option's strike price are the same.
Straddles are actually the most popular way to play market volatility because they allow you to profit when the stock moves up or down. You can think of it like "straddling a fence," having one leg on each side. And since there's no limit to how far a stock's price can go up or down, your profit potential is virtually limitless.
Now when it comes to placing straddles before an upcoming earnings announcement, the best way to profit is to make your exit before the announcement's made. Likewise, if you're placing a straddle after earnings come out, then the best way to profit is exit your trade within a few days after earnings – especially if there was no major movement in the stock. But if you're newer to options, your safest bet is to get in and get out before earnings.
About the Author
Tom Gentile is one of the world's foremost authorities on stock, futures and options trading.
With more than 25 years' experience trading stocks, futures, and options, Tom's style of trading systems and strategies are designed to help individual investors propel themselves past 99 percent of the trading crowd.