One of the fears about trading options is being hit by an event and the stock moving against you. A 5 contract trade opened at 2.00 can be vaporized in a day on some bad news. $1,000 nearly wiped out. Not easy to recover from that, either. I’ve been there many times. It stings, but if we use good risk management and control these events won’t be damaging. So, you may ask – ‘Bob, why even go there at all? – The market is open all other days besides earnings, why go through the agony of a binary event?” Good questions to ask, but let’s break this process down a bit to get a better understanding.
As always, let’s start with the charts. I find my trade setups using the chart and technical patterns that have historically worked for me. It is often these patterns that show me where stock acceleration, momentum and trends are starting to develop. If it just so happens the earnings even merges with a ripe chart pattern then so be it. The earnings result might even be a catalyst to drive more buyers into a stock. Have you ever wondered why a stock performs well even after missing estimates or perhaps even providing poor guidance? How about the ones who beat earnings and get hammered mercilessly the following day? Hard to explain, isn’t it? Make you scratch your head in amazement?
I have had some of my best trade results post earnings. In February we were long LNKD calls into earnings and it exploded after, while this past week the same thing happened with Whole Foods, but the charts told the story. Likewise, Rackspace ran up into earnings but the previous patterns were bearish post earnings, so there was a setup for a two way trade (strangle), and it worked out very nicely.
The technicals show patterns that arise over and over again. Yet, should we just avoid playing stocks/options around earnings? Four times a year most companies reveal their previous quarter’s activity, so with that ritual why would you panic? Option pricing obviously is skewed toward the high side around earnings in the short term, especially high beta names that could move heavily. However, after these events stocks tend to simmer down, at least we see the implied volatility decline. Did you see the action/reaction of IBM pre and post earnings? A big run up before, a huge drop just after and right back to where it was before the announcement. Lots of volatility and movement.
Concluding, play the game the way you see fit. Don’t let news, events and reactions influence your decision-making process. In the long term you’re probably going to be right – but sit tight.