Get Ready for Earnings Season With This Trading Strategy
Earnings season is upon us, again. To some investors, it probably feels like it’s always earnings season. They are almost correct. The formal season runs about six weeks and happens four times a year. That means about 46% of all trading days fall within an earnings season.
It also feels like many of the big moves occur in stocks after they announce their quarterly earnings. This is also to be expected according to standard financial theory.
Markets are generally efficient, according to the Efficient Market Hypothesis (EMH). This means investors and analysts around the world analyze a particular company trying to understand what its fair value should be. They then make buy or sell decisions based on their analysis.
Efficiency means that the current price of the stock reflects all of the information known about the company. In this interpretation of the EMH, no one individual has all of the information about the company. But, as a group, all of the investors and analysts following the company have a complete picture of the company.
Earnings announcements provide new information about the company. Of course, the quarterly earnings announcement includes much more than a number for earnings per share (EPS). The company releases its complete financial statement and management usually comments on their outlook.
All of this information is reviewed in real time by analysts and investors. They are all seeking profits and will make decisions as quickly as possible. The information often changes their assessment of the company and they respond by buying or selling, often creating gaps on the chart.
A Gap Can Provide a Trading Profit
A gap is an area on a price chart where no trading takes place. Examples of gaps are shown below in the chart of TripAdvisor, Inc. (Nasdaq: TRIP).
Sometimes the gaps are quickly filled as the most recent one in May was. At other times, the gap marks a significant change in the evaluation of a company. That appears to be the case for the other three gaps that are highlighted in the chart.
It may not come as a surprise to learn that each of the gaps highlighted in that chart are associated with the release of the company’s quarterly earnings report. It seems that every three months, analysts and investors are forced to evaluate their outlook for the company.
For TRIP, the gaps have generally been down and the news analysts learn from the company has been bearish. But, that isn’t always the case. Sometimes the gaps will be up when a company delivers a bullish surprise. This can be seen in the next chart.
This is a chart if chip maker NVIDIA Corporation (Nasdaq: NVDA). We could find similar patterns in a number of other charts. Gaps are common, and provide trading opportunities for traders.
Defining the Opportunity
Trading is an exercise in making decisions under uncertainty. When looking for a gap, the trader can be certain of the date they expect to see the price move. The date will either be the day earnings are announced if the announcement comes before the open or the trading day after the announcement if the earnings release comes after the close.
But, there is no way to know in advance whether an upcoming earnings announcement will trigger a large move this time. There is also no way to know in advance which direction the price will move. These factors are unknown but will determine the fate of any trade.
There are a number of strategies that traders can use to benefit from an expected price move. They could simply buy call or put options if they have a strong feeling about the direction of the expected move. These options, however, can be expensive in stocks that are volatile and losses can total several hundred dollars if the trader is wrong on the direction.
To eliminate the risk of calling the wrong direction for the trade, the trader could simply buy a put and a call which are trading with exercise prices near the current price of the underlying stock. This trade magnifies the risk cited above. Both options are likely to be expensive and buying two means risking more than $500. If a small move occurs, the loss would be equal to 100% of the purchase price.
More complex strategies may be used to benefit from the expected move while limiting the risk in dollar terms to a relatively small amount. One strategy that can be useful is the long iron butterfly.
This strategy involves four options contracts. The trader buys a put and a call with an exercise price that is near the current price of the stock. They then sell a put and a call with exercise prices an equal distance from the options that were bought. All options will have the same expiration date.
The higher and lower exercise prices are considered the wings in the trade. The options that are bought are considered to be the body of the butterfly. The risks and potential rewards of the trade are shown in the following diagram which is taken from The Options Industry Council web site.
This strategy is complex and rather than discussing the theoretical risks and rewards, we will use a specific example.
Specific Trading Strategy
A long iron butterfly can be constructed for TRIP. On Wednesday, TRIP closed at $37.31. The company is expected to release its latest quarterly earnings on August 8, after the close. Using history as a guide, the stock should make a large move the next day.
Using options that expire on August 11 provides exposure to that move. These options also limit the amount of time premium in the options to the minimum amount necessary to meet the trading objective of having a position for August 9.
The body of the iron butterfly will consist of options with an exercise price of $37. The legs will be $3 in length, requiring a $40 call and a $34 put. The specific trades are:
- Sell August 11 $40 call at about $1.30
- Buy August 11 $37 call at about $2.55
- Buy August 11 $37 put at about $2.15
- Sell August 11 $34 put at about $1.20
The total cost to buy the options is $4.70. This is offset by the income of $2.50 received for selling the wings of the trade. The total debit is $2.20. Since each contract covers 100 shares, this trade will cost $220 to open, before commissions which should be rather small at a deep discount broker.
Most brokers will require a commitment of trading capital equal to the maximum risk of the trade. For this trade, the maximum risk is the amount paid to open the trade, or $220.
The potential gain on the trade is the difference between the wings and the body, or $300 on this trade, less the premium paid or $220 on this trade. That makes the potential gain $80 on potential risk of $220 or 36%.
The trade delivers the maximum gain if TRIP is above $40 or below $34 when the options expire. That would require a price move of about 8% in the stock. On average, TRIP has lost 12.4% after announcing its earnings. This trade, therefore, has a high probability of success.
The advantage of an iron butterfly is that the risk is capped. The costs of the trade are known in advance and the potential gain is high based on the amount risked. This strategy could be useful for earnings season when many large moves are expected in stocks.