When combined with fundamental and technical factors (a 3-tiered methodology we call Expectational Analysis®), sentiment becomes a powerful tool for analyzing stocks, sectors, or the overall market. This is especially important as earnings season ramps up.
Last week was a whirlwind of corporate reports, which we tried to cover here, here, and basically everywhere.
But this week still brings plenty of earnings action, so we're going to harken back to our Benzinga feature that aired last month. Below is an excerpt of the article, which can also be found here.
It’s earnings season, a time of trepidation and anxiety for publicly held companies. But according to Schaeffer’s Investment Research, a privately held provider of stock and options trading recommendations, earnings season also provides a look under the hood of how companies have been managed over the past few months and how they may fare going forward.
According to Schaeffer’s, it’s also a time of opportunity for traders who can play options before the earnings announcements, or after the reports have been released. But they warn that playing options before the announcement is the riskier move, though potentially yielding large profits if the directional move is correctly predicted. However, jumping in with options after the release could set the investor on track with long-term directional movement.
Schaeffer’s Investment Research offers the following outlook and advice on options trading during earnings season.
Using Options to Profit During Earnings Season
One way to speculate on volatility using options is by employing a long strangle options strategy. Much like a straddle, a long strangle involves a bullish option trade and a bearish option trade, played simultaneously. Both the call and put are bought to open, and both trades share an expiration date. Unlike a straddle, however, a strangle employs a call and a put at different strike prices, usually slightly out of the money, that sits on either side of the underlying stock's current price.
Even Without a Crystal Ball, You Can Still Make Money
Event risks such as takeovers and earnings reports can cause stock prices to make huge, fast moves in either direction. In the traditional, old-line investment world, it might make sense to define the associated “risk” as a substantial decline in the share price. But in the modern trading world, with its hedge funds and short-term traders, who may as easily be holding short positions as long positions, and with the added flexibility investors have to profit on bearish views by buying put options, event risk is now “an equal opportunity” phenomenon. A sharp reaction to the upside could be at least as devastating to a short seller or a put holder as a sharp decline would be to a stock or call option owner.
One fascinating aspect of “date certain” events is that even though they can have an explosive impact on a stock or on the market, you as a trader can plan your strategy in advance and execute it just before the event is scheduled to occur. This means that you can position yourself to achieve big profits in a very short time period, often in less than a full trading day.
Pre-Event Trading: Putting Time on Your Side
The easiest way for option buyers to mitigate volatility going into a date certain event is to only trade events that occur during expiration week and simply buy front-month options the day before the known event date occurs. This may run counter-intuitive to other option buying strategies, in which time decay is a concern. However, for event trading, you are only going to be in the trade for a very short period of time (as little as one day). For the event trader, expiration week is the optimal time to make your move: Your leverage is at its greatest, you have the fewest dollars at risk, and the “penalty” of higher volatility premium is minimal.
Post-Event Trading: Capitalizing on Certainty
In trading “post-events,” because the element of uncertainty is removed, you can make decisions based on more factual information, while the options are much cheaper. If the news is sufficient to change the market's perception of the shares, this could create a sustainable move in the direction of the immediate price reaction, and buying options at much cheaper prices when the volatility premiums are minimal might make sense.
While Schaeffer’s Investment Research admits they can neither predict nor trade in front of “out of the blue” events like financial catastrophes and terrorist attacks, “date certain” events such as earnings announcements offer a unique opportunity for the option trader to capture potentially explosive stock movements in very short time frames. They add that by properly measuring investor expectations ahead of the event, you can help tilt the odds in your favor of getting the post-event direction right.
Learn more about Schaeffer’s Investment Research at www.schaeffersresearch.com.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.