Earnings season is on the way. This is when companies announce their earning numbers for the quarter. This release can wreak havoc with the stock price, or move the price very little, if at all.
The effect the earning release has on price is normally tied to analyst’s expectations before the fact. If the actual earnings number is “in line” with, meaning close to, the majority of analysts estimates, the price will likely move very little. This is due to the fact that the number was already priced into the stock price based on the analysts pre-announcement estimate. However, should this number miss the estimates, look out!
Price can and does swing wildly if this occurs. Normally, if the release beats analyst’s estimates, meaning the company did better than expected, the stock price will jump up. This is if there is no or limited verbiage to tone down future expectations along with the release. If the company misses the estimates on the downside, the stock may fall precipitously to get into alignment with the numbers.
How exactly can one trade earnings announcements while protecting their capital in case they guessed wrong on the direction of the potential move on the announcement? The most basic way is to simply buy an At The Money Call or Put prior to the announcement. This way your loss is limited to the premium paid for the option, should your guess on the earnings beating or lagging estimates be wrong. Let’s take a look at an example:
^AA^ is releasing earnings after the close today. The analyst’s consensus estimate is $0.65 per share. My data source is indicating that there is a 15% chance that AA will surprise on the upside, and a 54% possibility that it will issue a downside surprise. Remember, these are educated guesses, and not official figures that can be counted on. Right now AA is dropping fast, with all the July Puts up across the board. A trader who believes this will continue, and the numbers will drastically underperform the estimates could buy the 32.50 Puts AASZ at $2.11. There is fat open interest and nice volume on this option, however, its important to keep in mind, should earnings match or beat estimates, it could easily drop fast.
One can also wait for the earnings to be released and fade them the next day with options. Let’s assume that Alcoa surprises most traders with earnings that beat estimates. The stock may have a bounce up, but will potentially fade back to the downward trend over the next several days. If this is your guess, you would simply wait until after the announcement’s initial move then buy the Put cheaper and wait for price to drop back into the dominant trend. If you decide to trade in this manner, I would suggest giving yourself time for price to come back into line by purchasing options with at least a month of time premium left.
A safer way to play earnings misses, particularly when you believe that earnings will miss estimates by a substantial amount but simply don’t know in what direction, is to put on an Option Straddle. A Straddle provides profits if the stock moves substantially in either direction. It is the simultaneous buying of a Put and a Call at the same strike price and expiration date. This position has the trader covered regardless of the earnings surprise, up or down. However, the stock price needs to move enough for one leg of the Straddle to increase enough to counteract the losing side, resulting in profits.
This should be an exciting week for stock option traders. Remember to only use risk capital when trading any option strategy, regardless of how confident you are.
David Goodboy is Vice President of Business Development for a New York City based multi-strategy fund.