One of the most tempting things to do is buy a stock that's in a good technical setup ahead of earnings. Top fundamentals? Check. Sound chart? Check. Signs of institutional buying in recent days and weeks? Check.
What's not to like? The market seems to expect a solid report, so why not buy?
If you've tried this strategy, it may have worked some of the time, but plenty of other times, it didn't.
The bottom line is that it's practically impossible to tell how a stock will react around earnings.
Even stocks with bullish-looking charts fall apart on seemingly solid numbers.
Of course, having a big profit cushion makes it easier to hold through earnings. A stock might gap down 5% to 10% on weak results, but with a 30% or 50% profit cushion, that's not too big a hit. But it's a different story when the profit cushion is small.
One way of dealing with volatility around earnings reports is by using inexpensively priced weekly call options.
The options strategy is a way to capitalize on the upside potential of a stock's move around earnings. Even better, the strategy reduces the risk of a negative reaction to earnings by limiting how much you can lose. The cost is reasonable, much less than what you would typically risk when buying actual shares of a stock.
One call option gives you the right, but not the obligation, to buy 100 shares of a stock at a specific price (the strike) within a specific time period. You pay an option premium for this right. Five stock option contracts represents 500 shares.
Here's how it works:
Chipotle Mexican Grill (CMG) closed at 589.93 one day ahead of its Q2 earnings report on July 21 last year. A 590 call option had a premium of $20.58. The cost would have been $2,058 (100 x $20.58) to control 100 shares as opposed to shelling out $58,993 to buy the stock outright.
To calculate the maximum risk for the trade, take the option premium ($20.58) and divide by the stock price (589.93). That gave you a trade with 3.5% downside risk.
Chipotle gapped up the next day and opened at 650 (1). You could have exercised the option and paid $59,000 for 100 shares rather than $65,000. That's a profit of $6,000, but you have to subtract the amount paid for the premium ($2,058). The net profit is $3,942.
If Chipotle had gapped down badly on weak results, the most you would've lost was the option premium you paid ($2,058). Losing 100% of an option premium is small in comparison to how much money you could lose if you owned the stock itself.
In IBD Leaderboard, leading stocks with attractive call options are noted in the week ahead of their quarterly results.
To review:
•Look for top-rated stocks near buy points — stocks you truly want to own — just before earnings.
•Target weekly options with a strike price just out of the money and close to the proper buy point of the stock itself.
•Calculate maximum risk by dividing cost of weekly premium by current stock price. Look for a range of 2% to 4%.
•Buy weekly call options during the session before the company reports earnings.
