An Earnings Trade That Could Win If This Stock Goes Up or Down
Earnings reports are often market moving. This may be surprising at first. After all, investors know when earnings are coming. And, analysts spend many hours preparing detailed estimates on what earnings will be.
Yet, even though the time of the announcement is known in advance and some of the brightest minds on Wall Street use reams of data to get ahead of the news, there are often surprises. There are actually a number of reasons for this.
Probably the biggest reason for surprises after an earnings announcement is the fact that analysts are often wrong. In a typical quarter, we will usually see about 65% of companies report earnings that are better than expected. Another 25% will miss expectations and typically less than 10% of the reports will come in where analysts expected the earnings to be.
Given this track record, it seems safe to say that many analysts develop trading strategies based on the expectation that the company will report earnings that are either better or worse than expected.
Now, even though we know analysts are more likely than not to be wrong, some traders may still be surprised that the stock price moves so much after the announcement. For example, it is not uncommon to see a company miss expectations by just one penny per share and the stock sells off by 10% or more.
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Again, there are a number of reasons for this pattern. But, probably the most important reason is the fact that the earnings miss is a signal to the market. The company is in effect signaling that analysts may not understand the company very well and this creates questions about what the future holds.
When we realize than an earnings miss can indicate earnings estimates can no longer be considered reliable information, the large price moves are more understandable. Traders are forced to reprice the stock on the expectation that they know very little about the future.
The truth is, traders always know very little about the future. When a company meets expectations, the trader still has no idea what that means for the next quarter. But, traders have more confidence that they know what to expect for companies that meet or beat expectations.
It’s the company that misses expectations that creates fear about the future. And, in the stock market, fear generally translates to higher volatility.
Fear, Uncertainty, Doubt…and Profitable Trading Opportunities
As traders, we have come to expect fear as a natural part of trading. But, fear has long been a part of the business world. Many sales strategies are designed to benefit from fear, uncertainty and doubt. The idea is popular to have its own name – FUD for Fear, Uncertainty and Doubt.
If you’ve ever shopped for a car you are familiar with FUD. You decide to buy a car and settle on the price. It’s a lot money and the salesperson knows you have some FUD. So, they offer an extended warranty, paint sealant, fabric protection, undercarriage coating and other products that reduce the FUD.
Many consumers worry about their purchase so much, they buy the products that help them rest easier. That makes sense. A new car can cost $30,000 or more. Complete protection for just a few hundred dollars per item seems inexpensive.
FUD exists in other areas of business, which explains a lot of the services people purchase. We are willing to exchange a few dollars for less FUD.
This is also true in the stock market. With an earnings report, FUD can grow. Traders fear the unknown of what will happen after the announcement is made. They are uncertain as to how they should react and they may doubt their own ability to react when the time comes.
Options Strategies Can Benefit From FUD
For example, a long straddle can be used to benefit from an upcoming earnings announcement. This strategy involves buying a call and buying a put, both with the same strike price and expiration date. Together, the combination of options creates a position that should profit if the stock makes a big move either up or down.
This trade offers a big payoff for a big move, either up or down. The risk and reward payoff diagram from The Options Education Council web site is shown below.
The risks of this trade are strictly limited to the amount you pay for the options at the time the trade is opened.
A Specific Trade in a Volatile Sector
Micron Technology, Inc. (Nasdaq: MU) is expected to announce earnings after the close on July 3. The stock has recently seen volatility expand in expectation of this announcement. This is shown in the chart below.
Traders seem to be expecting a big move in the stock price on the earnings announcement. The chart shows the stock has a history of gapping at the open on the day after the earnings release. Gaps can be seen in March and December after the last two reports.
While the stock gapped higher on the most recent reports, the track record in the long run is mixed. Micron has exceeded expectations eighteen times in the past seven years, a beat rate of about 56%. On average, the beat rate is about 65% in the long run.
Variability in the reaction to earnings means the stock could move up or down. Buying a put and a call sets up a trade that can benefit from either outcome.
MU is currently trading at $30.83. There are options available with an expiration date of July 14. This allows us to maintain exposure to the stock even if the company delays the announcement by a few days.
Both a call and a put are available with an exercise price of $30. The call closed at $2.20 on Monday and the put closed at $1.35. It would cost a total of $3.35 plus commissions to enter this trade.
Given the entry price of $3.35, the trade will be profitable if MU rises above $33.35 or falls below $26.65. These values are found by adding and subtracting the premium paid to open the trade from the option exercise price.
While the maximum loss is $3.60, the loss will be smaller than that if MU closes at any price other than $30 which is the single point where both options would have no value.
How Big a Move is Likely?
This trade is most profitable if MU makes a large move on the earnings announcement. The stock has a history of doing this. In each of the last two quarters, the stock moved more than 13% on the day after the news was released.
The chart above indicates the move could be even larger this time. The average true range (ATR), calculated over the past 14 days, is shown at the bottom of the chart above. This indicator is a measure of volatility.
ATR(14) rose before each of the previous two earnings announcement. But, the recent move in the indicator dwarfs the magnitude of those earlier moves. It is possible the recent volatility was due to traders positioning for the earnings announcement.
This strategy, a long straddle, is useful for almost any stock before a quarterly earnings announcement. For MU, the strategy requires buying an equal number of July 21 $30 calls and July 21 $30 puts.
While this strategy can work with any stock, it is usually best to limit trading to highly liquid stocks like MU. Deep liquidity makes it possible to exit a trade after the news is released.
History shows the best time to exit this trade in MU could be on the day after the earnings announcement. With the liquidity of MU, that should not be a problem.