Every quarter the stock market goes into the earning season, that lasts for about six weeks. During this time, many trading opportunities arise, as the volatility takes off.
After a company reports earnings, we can often see its stock gaps.
If you buy the stock before it gaps up, you can gain profit when the stock opens sharply higher. There is another side of it – impossibility to control the risk if you buy the actual shares. For example, just as it can gap-up 5% in your favor, it can gap down 5% against you. It’s tough to cover your position “inside” the gap, as the number of market participants is extremely low during the pre-market and post-market hours.
In the example below, if you bought SMAR at $59.00 right before the earnings report, you’d most like be able to cover your position only at around $55.00 at the market opening. That’s over 7% loss from a single trade. You don’t want to take such a risk.
How options can help control the risk
Options can be a solution in terms of risk control if you want to take advantage of the volatility during the earnings season.
An option is a derivative instrument that allows you to conduct the transaction in the underlying asset. There are two kinds of options – call option and put options.
Call options – when you buy a call stock option, it gives you the right but not obligation to buy the underlying shares at the specified price within a particular time.
Put option – conversely, when you buy a put option, you can sell the underlying shares within the specified period.
The Strike price of an option is the price of the stock at which you can exercise your option (buy or sell the underlying stock.) The call option is “worthless” when the strike price is above the current market price. The put option is “worthless” when the Strike price is below the market price.
When you buy either call or put option, you will need to pay a premium. Essentially, the premium is a fee for the opportunity to make money from an option. The premium is the only risk you’re taking when buying options. If the underlying stock doesn’t go your favor, you don’t have to exercise the “worthless” option.
Therefore, with options, you can still keep the profit potential of the huge price changes from the gaps while fixing the amount you risk to the cost of an option premium.
Basic option strategy
You don’t want to hold the shares of a company during its earnings report release. If it gaps (and most likely it will), and you catch the gap, not in your favor, it can hurt your account greatly. Even if you’re prepared to take the loss from the gap (you adjusted your position size accordingly), over the long-term, there is a risk to not be able to make any profit from such strategy. Your losses would be too big compared to the profits.
That’s why it’s effective to use options to take advantage of earnings reports volatility.
First, you want to see a good technical pattern in stock. That can give you the odds that the stock will start moving in your favor even before the earnings report. Such patterns can be the Cup and Handle, Triangle, Flag, etc.
Second, Look for a slightly out-of-the-money weekly or monthly call option. The Strike price should be a little above the underlying stock price.
Third, calculate your risk of a possible trade. Divide the option premium by the stock price, and multiply by 100. In this way, you can quantify the risk in the percentage form. You need the setups with the risk of no more than 4%. The reason for this particular number is that the majority of the moves caused by earnings reports can reach 10% price change of stock. Even if you’re right in less than 50% of all your trades, you can still be in profit after a sufficient statistical sample.
Goldman Sachs Options Advice
Buying options before earnings can be a lucrative strategy. One of the most prominent investment banks, Goldman Sachs, also finds the system workable. Goldman’s team that specializes in options trading studied the price history data excessively. They focused on market behaviour before and after the earnings report.
In general, the team found that stocks tend to rise after their earnings reports, so it makes sense to buy call options.
The bank dug deeper and discovered the way of how to filter the stocks to get the stocks with a higher probability of growth after earnings reports.
It turned out that the stocks that declined ahead of earnings would be more likely to grow after the report. We’re talking about two weeks ahead of earnings. If we filter the stocks in this way, the researchers found, the average profit from such stocks is 18%, which is 4% greater than without picking underperforming stocks.
Why would such pattern occur? According to Goldman, if a stock has bad expectations ahead of earnings, investors tend to sell it to reduce the exposure to the uncertainty around the stock. After the earnings report is released, it often happens that “it’s not as bad as it seemed” and the investors rush to buy back the stock as their initial reasons to hold the stock are viable again.