First off, save yourself a lot of time and do not read any of the earnings reports and do not bother listening to any of the analysis. For traders it does not matter. All that matters is how the stock price reacts once the news is out. What sounds like good news can actually be below expectations and cause a stock to get hammered and vice versa. Just watch the price. It will reveal all that you need to know. Second, its critical to understand that premium in an underlying option increases as a stock heads into earnings (a rise in implied volatility) and then collapses right after the announcement. This is why a trader can buy call options just before earnings, see the stock rise $3.00, and not make any money. So what to do?
One of my favorite strategies is to scan the market pre-cash open to see how stocks that released earnings after the previous day's close (or earlier that same morning) are faring. I am most interested in stocks that are trading down at least 2%, or more, on the news. This is enough to create a little panic at the open as call buyers seek to dump their positions and stock holders scramble to buy puts to protect themselves. In this scenario, I am looking to sell at the money or slightly out of the money naked puts very near the open. At this point, implied volatility has spiked and I want to be a seller of this spiked volatility. Once I have sold the puts, I can then monitor the stock over the next several hours to see how it behaves. What is nice about this trade is, the stock can do three things and your option can still make money. First, it can rally,which is the best scenario for obvious reasons. Second, it can quiet down and trade sideways. Implied volatility gets sucked out of the option and the puts you sold at a high price quickly begin to deflate. Finally, the stock can actually drift slightly lower and a trader can still make a little money as implied volatility collapses once the initial panic is over. Of course, the stock can open lower and just keep on going -- the scenario you do not want to see in this situation. This is where the most important part of a trading plan comes into play. Determine how much money you are willing to risk on the play and then act like you are a professional trader and place a stop.
The other strategy I like to look for is the run away gap up break to the upside -- a move of at least 4% or more at the open. This type of move will very likely continue. In this case, I like to let the stock open, wait for its first pullback during the opening 30 minutes, and use that pullback to buy one strike out of the money calls. (Ideally the pullback is just after 30 minutes of trade. This way the implied volatility has collapsed and a trader can get a fair price on the options). If the stock can then make new highs on the day, it will typically have a powerful run and I will use this run to start scaling out of my call options.
I typically do not make any bets prior to earnings. It is too much of a coin toss and you can end up tying up money in a dead end reaction while there will be plenty of juicy moves you can play after they actually happen. Just sit back and scan and be ready to pull the trigger.
John is a Commodity Trading Advisor with Razor Trading. McGraw Hill commissioned him to write a book entitled Mastering the Trade, which was released in January 2006. Carter has also been featured on ABC Money. He and Hubert Senters founded and run the Trade the Markets web site.
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