What's Better: Earnings Season Or Derby Prep Season?

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Earnings season officially kicked off yesterday with Alcoa Inc AA. Ahhh, earnings season. Aside from Derby Prep Season… earnings season is my favorite season.

The thing about earnings season is that decisions are obviously a little more pressing. It’s not unlike the home stretch of the derby – which is notorious for being the hardest race to handicap. Races are won, and lost in the home stretch. Some horses thrive there. And some completely fizzle out. The homestretch tests what a horse is really made of. The way I handicap what I think will happen in the home stretch of the derby is a lot like how I trade earnings.

Late money is the smart money.

In racing, I always wait till the last possible moment to place my bet. You never know what’s going to happen. In 1994, just before the gates opened up at the Derby, the sky also opened up with a torrential downpour. No one would have predicted that Go For Gin would win the race – unless they were specifically looking for the horse bred for an off track.

For the same reasons, I always wait as long as I can before I trade earnings. What am I looking for? Any number late game developments. I keep a close eye on option time and sales. Sometimes I might observe sizable (potentially even institutional) option order flow. This could either talk me out of my trade or build my confidence.

But here’s something you always need to think about in order to take institutional flows in context. There’s always another side to that trade. And in some cases, institutions take large option positions in an attempt to hedge a sizable equity position through earnings. You always need to think through what might be behind the trade on your screen. I also want to look at what the broad markets are doing in general.

“All ships rise in a rising tide” so the old saying goes. So I keep a close eye on what the broad markets are doing and think through how that could impact my trade.

Study your racing forum!

When I’m at the track, I use just about every data point in the Daily Racing Form. Similarly, when it comes to earnings, I pay close attention to Market Maker Move which summarizes the options pricing data to suggest how strong of a move (though not the direction) the stock might have post earnings announcement.

This is all crystalized into one smart little data point. It’s like the Beyer speed figure of earnings trading. I also like to look at options time and sales, and options product depth to get a better understanding of what the crowd seems to think about the stock.
Probabilities

I’m all about probabilities. Place bets over wins. Exacta boxes. When it comes to earnings trades, if I’m a buyer, I always use probability analysis tools to look for a trade that has at least a 50% probability of the options being worth something at expiration. It’s for that reason, that I’m usually looking to take a position that is modestly in the money.

You would never want to do this:

A $50 dollar win bet is a low probability trade. Lucky for me the 16 horse was Animal Kingdom. I hit the win and it paid $43.80 after going off at 20:1 odds resulting in this:

Use exotics.

I often use exotic wagers to reduce the amount of capital that I‘m spending and at the same time, enhancing the potential rewards. In racing those are exactas and trifectas. But in earnings season, I often use spreads and Weeklys options to reduce the amount of capital I’m putting at risk while still anticipating a nice reward.

The popularity of Weekly options among traders continues to expand. Especially for retail investors. The reason? Weeklys offer the ability to make very tailored speculations on short-term price moves in the stock. With fewer days to expiration, they’re less expensive than other options at the same strike price in further expirations. And they give you a lot of bang for the buck, because if the underlying stock or index makes a big move, Weekly prices can change by a much larger percentage than further dated options. That’s what makes them “stretch run” trades.

What do I mean? Let’s use the theoretical options pricing formula on the thinkorswim platform to arrive at some theoretical values. All theoretical values in the following example were derived using the theoretical pricing tool found in the Trade page of the thinkorswim platform.:

Let’s assume we’re looking at a $100 stock with a volatility of 35%. If the stock price moves from $100 to $101 (assuming no change in volatility), the 100 strike Weekly calls with seven days to expiration theoretically would go from .90 to 1.44. Meanwhile, the 100 strike calls with 21 days to expiration would go from 2.23 to 2.76. The Weekly options rose 0.54, or about 60%. The 21-day options rose 0.53, or about 24%. Thus, Weekly options have the potential to increase by a greater percentage for the same price change in the stock.

What makes the Weeklys move so much? The short time to expiration means that Weekly options have relatively high gamma. That high gamma means that their prices respond very quickly when the stock or index price changes. But an important word of caution: gamma works in both directions. The same forces that cause upward momentum can also serve to pull the price down. Gamma measures how much an option’s delta moves when the stock price changes; delta measures how much the price of the option changes.

A good way to think about delta is how much the option “acts” like stock. When gamma is high, a small change in the stock price increases the delta, pushing the option to act more like stock as it changes closer and closer to parity (dollar for dollar). That’s what accounts for the very high percentage appreciation you can see in Weekly options. The high gamma is what may make them interesting trades for earnings announcements or other news releases.

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High Roller

So let’s say you’ve got money to burn and want to consider buying a little extra time. Why not just buy options with a further expiration date? You could buy more to get the gamma equal to the Weekly position, and the time decay would still probably be lower. The risk here is that the larger position in options with a further expiration date has a much higher vega, or sensitivity to changes in implied volatility. Remember when I said that Weeklys let you tailor the speculation? Weekly options have low vega, and don’t move as much when volatility goes up or down. That means that you can focus more on what the stock price is doing. With longer-dated options, you have to be aware of what volatility is doing as well.

Currently A Small Field

Weeklys are currently only available on the most popularly traded stocks and many indicies as well. Obviously, you won’t be able to use Weeklys for every earnings play you might be interested in making. Individual stocks sometimes have their biggest price swings around earnings numbers. If you’re buying Weekly options to speculate on a big price move on earnings, doublecheck to make sure the earnings are announced before the Weeklys expire. Keep in mind that if you guess wrong and the position moves against you, you could lose the entire investment amount spent on the option. Also, because they are short-lived instruments, Weekly options positions require close monitoring, as they can be subject to significant volatility. Profits can disappear quickly and can even turn into losses with a very small movement of the underlying stock or index.

In handicapping and in trading earnings, if you’re going to enter the field… be prepared for unexpected events. Last earnings season, I had a few calls where I was directionally right based on top and bottom line outcomes but the company revised guidance and the stock moved in the opposite direction. Earnings trading is not for the faint of heart and has its risks.

Disclosures: Probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring. Past performance of a security or strategy is no guarantee of future results or success.

Image photo credits: Cheryl Ann Quigley / Shutterstock.com

Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.

Supporting documentation for any claims, comparison, statistics, or other technical data will be supplied upon request.

Investing involves risks, including loss of principal. Past performance is no guarantee of future results.

Commentary provided for educational purposes only.

Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return.

© 2015 TD Ameritrade IP Company, Inc. All rights reserved. Used with permission. TD Ameritrade, Inc., member FINRA/SIPC.

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Posted In: OpinionTrading IdeasAlcoaKentucky DerbyNicole Sherodd
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