We are currently in earnings season - a time when companies announce their earnings results from the past quarter. These much awaited announcements can cause quite a bit of volatility in the markets, especially when the results are something other than expected. But, as a trader you can learn to capitalize from this volatility and profit from some unique trading opportunities.



Before a company ever announces its earnings, analysts are out there interpreting information and doing their best to predict what that company's earnings will be. If the actual earnings are much different from the estimated number, we will generally see a gap in the stock. That gap occurs because investors were blindsided by what the actual earnings were and will either sell that stock in droves, (causing a gap down), or buy that stock, (causing a gap up). The direction of the gap will not always make sense. For instance, we will have instances of a company beating their earnings estimates but their report may contain some information that can be interpreted as a slow-down in sales in the future. That slowdown may be the piece that investors focus on and they sell their stock because of that forward-looking guidance. Although the earnings were good the future-looking guidance was bad, so investors may feel it is best to sell their stock. And the larger than usual selling pressure may cause the stock to gap down regardless of the positive earnings. We will also see instances of a reverse situation. Bad earnings accompanied with some good information may, at times, attract enough interest in the stock to cause a gap up. The point is that even if you knew exactly what the earnings would be for a company, it still would be difficult to predict what the investors would focus on and what direction that stock would move. This can make holding a position over an earnings announcement very risky but there are ways to take advantage of all that uncertainty.

When the situation is right, I will create a strangle over an earnings announcement. A strangle is a hedged play in which you purchase an out of the money call option and an out of the money put option on the same stock. The idea is that if the stock gaps big after the earnings announcement, you will lose on one side of the trade but make money on the other side. If the gap is big enough, your profits from the winning position will offset your loss and leave you with a net profit on the trade.

You need to be careful with this because if the stock does not gap far enough, you will end up with two options that are worthless. You need to set this trade up on those stocks that have the potential to gap big after their announcement. Here are the guidelines that I use to help get me in those trades with the highest potential to gap big. The first thing I am looking for is a stock that has an average daily range of $1 to $1.50. This ensures that I am doing this trade on a stock that can move. The second piece is that I prefer to do this on a stock that has recently been in a strong uptrend. It seems that stocks that have really been in favor can create even more excitement around earnings. If the overall news is good, you can see even more buying pressure into that stock causing it to gap up and if the news is bad all those buyers who had been attracted into that stock during the uptrend panic and begin to sell causing a big gap down. Remember, we need to see a big gap in either direction to offset the side of the trade that will go against us.

The more money we spend on our options the more difficult it will be to make money on this trade. We are buying out of the money options on this trade and to keep the cost of the trade down, I prefer to buy as little time as possible. My third criterion is that I do this trade on companies that are announcing the week or two before options expiration. We will only be purchasing a small amount of time in this case and thus increasing our success rate on this trade.

Now that we have narrowed down the group of stocks on which to implement this strategy, let me show you how it works. Let's take a hypothetical example of XYZ stock that is announcing earnings on the Tuesday evening before October options expiration. The stock has been in a strong uptrend and has an average daily range of $1. It meets all my criteria so I can go forward with setting the trade up. XYZ is trading at $72 and we want to purchase an out of the money call and an out of the money put so the trade will look like this:

Purchase 10 Oct. 75 calls @ 1.20

Purchase 10 Oct. 70 puts @ 0.75

This trade will cost $1.95 to put on and you can enter the trade anytime before market close on Tuesday. I generally exit this trade the next morning within the first five to ten minutes of the trading day by selling both options. If the stock gaps up, my puts may be worthless or have only $0.05 in them. I will take the money for the puts if there is any there, and if not, I will hang onto those puts until expiration in the rare case that the stock may sell off and those puts may have some value on expiration Friday. If the gap up was big enough, I will have enough profit from my call options to offset the loss in my puts and come out ahead on the trade. If the stock gaps down, I still sell both options. If there is no money in the calls, I will hold onto those until Friday in the rare case that the stock rallies and I will be able to sell the calls on Friday.

One important piece to keep in mind is that when you buy these out of the money options, you are buying all time value. When the markets open after an earnings announcement, the market makers usually take all that time value away. One way to gage how far the stock needs to move before you will be profitable on the trade is to take your total investment, (in this case $1.95), and add it to the call strike price:

75 (strike price) + 1.95 = 76.95

XYZ must gap up to $76.95 before you are break even on your trade. That means that the stock must gap above $76.95 to make money. If there is a major resistance level around 75, this is probably not the stock to do this strategy on because it will be too difficult to make money.

If the stock gaps down, it must move below the put strike price minus the cost of the trade before you are break even:

70 (strike price) - 1.95 = 78.05

Because the market makers take away all the time value that you purchased, you will hit the break even mark if XYZ gaps down to 78.05. You want to make sure that the stock has the ability to gap below that price before you put the trade on. Make sure there is not a major support level between where the stock is currently trading when you put the trade on and the price at which the trade will be profitable for you. If there is a major support level somewhere near that profitability, your best bet is to find another trade.

This is a trade that I will do once or twice an earnings season, only on those stocks that meet my criteria. Take an earnings season or two to practice trade this strategy. If you will follow these guidelines I've set up in this article, you will be able to profit from some of the volatility and uncertainty during earnings seasons.

If you would like to learn more about technical analysis and profitable entry and exit points, join me in one of my free online trading seminars or come see me live in my informative and exciting two days seminar "Technically Speaking". Hope to see you soon!

Markay with BetterTrades