Earnings announcements create a problem for traders as we often see an overreaction to the announcement. This overreaction takes the form of an unusual amount of buying or selling pressure. Because most earnings are announced after the market has closed this buying or selling pressure builds up overnight and causes the stock to gap up or gap down. The stronger the buying or selling pressure the more the stock will gap.
Don't think you can guess which direction the stock will gap. Good earnings do not always equate to the stock moving higher and bad earnings do not always equate to the stock moving lower. This means that if you want to trade a stock over earnings you must be in a hedged play which means you are covered if the stock goes up or if the stock goes down.
My favorite hedged play is a simple strangle. In a strangle you buy an out of the money call and an out of the money put. You must do this when the options are cheap so the best time is near expiration. Always buy front (or current) month options on this trade. And you only want to do this on volatile stocks that may gap big when the earnings are announced. When the markets open after the announcement you want to sell both options to profit from the overnight gap. It is very likely that one option will be worthless, ie: the stock gaps up, you sell your calls at a profit and your puts are worthless. Hold onto those puts as sometime between now and options expiration the stock may fill the gap. Since you will have one side of this trade that goes against you it is critical that you do this strategy only on stocks that are more volatile and are likely to have significant moves.
Recently, in my trading seminars, my students and I planned out and entered two strangles, one on Apple (AAPL) and one on eBay (EBAY). The chart below shows how AAPL reacted to their earnings news. The entry to the trade was on January 12, 2005 when AAPL closed at $65.46. We bought ten contracts of the Jan. 70 calls and ten contracts of the Jan. 60 puts for a net debit of $1.90. The next morning AAPL gapped up and we sold our calls for $4.00 while the puts expired worthless. That netted us a profit of $2,100 overnight.
The setup for the EBAY strangle was similar to the AAPL strangle. EBAY was scheduled to announce earnings after the bell on Jan. 19, 2005. Near the end of the day on the 19th we bought ten contracts of the Jan. 105 calls and ten contracts of the Jan. 100 puts for a net debit of $3.40. EBAY closed on the 19th at $103.05. You can see on the chart below that EBAY gapped down an amazing 16.36 on the open. Obviously the 105 calls were worthless but the 100 puts had increased to $ 14.50. So that would have given us a profit of $11,100 if we had sold at the open.
Generally you want to exit this trade in the first couple minutes of the market; however, having a thorough understanding of technical analysis may enable you to pull out even more profit by analyzing the intra-day chart. By using techniques taught in my Technically Speaking class we used the intra-day chart to stay in the trade as EBAY continued to drop after the open. We were able sell our puts for an extra 3.9 points for a total profit of $15,000 rather than the $11,100 if we had sold at the open.
The strangle is the safest way to make money over an earnings announcement when it is difficult to know which way the stock will move. Stick to some simple rules to maximize your profits. Use this strategy only on the most volatile stocks and keep the cost of the trade to a minimum by buying a very small amount of time. Then sell the profitable option at the open or use intra-day charts to remain in the trade as long as it is going in your direction.
There are still around 2,100 stocks left to announce earnings in February. Don't miss this opportunity to learn how to use the strangle. It is a valuable tool in the arsenal of the trader.
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!