Dear Reader,
This week, I’ve already told you a bit about how I trade earnings.
I’ve even given you the top 10 stocks I’m watching heading into earnings season.
But today, I’m going to go deeper and show you everything you need to know to be successful over the next few weeks.
Because when it comes to earnings, most traders get it dead wrong.
Most will try to guess whether a company is going to beat or miss on earnings, and place their bets accordingly.
But this is a terrible idea.
Because even if you guess right, the market will likely have other ideas.
If you’ve traded earnings this way before – and gotten burned – you know exactly what I’m talking about.
It happens every single earnings season. A company beats expectations only to see its stock price suffer. Or a company misses and the price inexplicably goes up.
So even correctly guessing a beat or miss ahead of a company’s quarterly earnings call is not a guaranteed win for your portfolio.
Whether you’re a stock trader or an options trader, earnings can be a frustrating time. Many traders avoid earnings like the plague – because of the phenomenon we’re going to talk about today.
More on that in a moment…
First, here’s why most traders get killed during earnings season…
This “Swift” Profit Explains My Earnings Approach
The best way to trade earnings is to think like a ticket scalper.
Let me explain…
The hottest ticket last year was Taylor Swift’s Eras Tour, with obsessive fans paying thousands of dollars for a seat in sold-out stadiums across the country.
If you were a scalper who managed to bag an Eras Tour ticket at face value (the most expensive seat was set at $499), you likely hit a big payday when you sold your ticket to one of those obsessive fans.
As tickets sold out and scarcity set in, prices went crazy, with the resale price hitting an obscene average of $3,801 – a 661% gain on the best seats in the house.
Of course, in order to get that kind of return on your investment, you’d have to sell your ticket BEFORE the concert.
Try to sell it after, and that ticket is worth $0.
It seems obvious, but if you’ve got a front-row seat to the action, you better sell it before the show.
Earnings are no different.
Most traders get their “ticket” – a position in either the stock or the option – and hold it through the earnings announcement, hoping for news that’s going to move the stock in their direction.
But just as with concert tickets, after the “show” – in this case, the announcement – your position becomes worthless for exactly the reasons I just mentioned.
You might guess right on whether a company will beat or miss. But you can’t guess how markets are going to react.
So what you’ve got is a classic “Buy the rumor, sell the news” situation. Get in when everyone is speculating and driving up prices, and get out before the actual news brings prices back down to earth.
But it’s not just this time-tested aphorism that informs my approach to earnings.
No, I think like a scalper because all the tradable price action happens BEFORE the earnings announcement – and there’s an obvious pattern traders can leverage for profits.
Profit From the Rush, Avoid the Crush
It all comes back to Implied Volatility.
Now, if you’re a buy-and-hold investor, you’ve probably been taught by the talking heads on CNBC that volatility is a bad word.
But for traders operating on a limited time horizon, volatility isn’t just a helpful tool. It’s essential to your strategy.
Because, despite what the financial media would have you believe, volatility is a good thing – because it signals to traders that stocks will move – which is exactly how shorter-term trades deliver profits.
Implied Volatility is the market’s prediction of what’s next for a security’s price. The higher the IV, the more likely a stock will make a move.
This is key to my earnings strategy – because IV spikes in the runup to earnings, and prices usually follow.
Among traders, this is commonly called “IV Rush.” It happens as traders speculate on earnings and get into position to profit from the announcement.
Now, remember, we’re buying the rumor and selling the news here…
Because once a company releases earnings, IV tanks. Once the speculation is over and the markets have hard data, all that extra juice is immediately sucked out of the stock.
This is what we call “IV Crush.” And it’s why holding your positions until after the earnings announcement is a huge mistake.
Let’s walk through it with an example from last November. I’ll show you how the stock performed – and then show you the option trade (and explain why I prefer trading options before earnings).
Case Study: Abercrombie & Fitch (ANF)
First, let’s take a look at how you would have done playing Abercrombie & Fitch Co. (ANF) stock ahead of earnings.
On November 14, ANF was trading at $68.68. Buying 100 shares of stock would have cost you $6,868.
ANF announced on November 22 before market open (BMO), so if you were thinking like a scalper, you would have exited your position on November 21, BEFORE the announcement to limit your exposure to any downside.
During the life of this 7-day trade, ANF went from $68.88 to $74.03, netting $361 profit – a nice 5.3% return.
A 5.3% profit on a stock position in a week is a pretty great return on your capital (a 275% annualized gain, if you’re counting).
But during earnings season, I prefer to use options.
Let’s walk through the ANF option trade – and I’ll show you why…
The first reason I love options – less capital risk. You can control the same 100 shares of stock by buying a single call option at a fraction of the cost.
And – thanks to Implied Volatility – the call option yielded 40.8% ROI. But your risk was only $490 – just 7.13% the cost of 100 shares of ANF.
That’s 7x better ROI than the stock trade – in about half the time, with around 93% less capital risk.
But here’s why options are the hottest “ticket” ahead of earnings.
Why IV is the Secret to Earnings Profits
You might think the option trade delivered a 7x better ROI because options are a leveraged investment, designed to deliver outsized gains on small stock moves.
That’s certainly part of it. But it’s not the whole story…
You see, Implied Volatility is critical to options pricing. As IV rises, so do options premiums. Because the more likely it is that a stock’s price will change, the more expensive it is to take that bet and get in on the action.
What’s more, IV can be measured and graphed – which means we can find a tradable pattern.
Here is an example of the historic IV chart on ANF on the day we exited the above trade:
The green “E” triangles are earnings announcements. The red line is the IV – which indicates how expensive the options are.
As you can see, the IV rises exponentially in the weeks leading up to earnings. In other words, option premium increases during the weeks before earnings on ANF.
In our call example above, we made MORE money thanks to IV Rush – and got out BEFORE IV Crush set in.
You can see it on the chart – once ANF announces earnings, the red line goes straight down. And so does the value of your option.
IV is awesome if you know how to use it. Unfortunately, those who don’t often get crushed – just like a scalper trying to sell a ticket to last night’s show.
And here’s some great news: This IV rush pattern happens for most stocks in the runup to earnings. Some are bigger than others. This pattern is one of the most reliable patterns in trading and properly harnessed will amplify your gains and reduce your losses.
While volatility is unpredictable, when we see these kinds of spikes over and over again, we know we have a tradeable pattern – and that usually leads to profits.
Whether you sit out earnings season… or you’re a die-hard earnings trader… or you’ve never even tried, I want to hear from you!
Tell me your about your biggest earnings season wins… your horror stories… why you do or don’t trade earnings… or ask me anything you want about my earnings season strategy.
You can contact me right here.
Good trading,
Tom Gentile
America’s Pattern Trader