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By: Costas Bocelli — October 16, 2013

My #1 Tool for Earnings Season

Now that Washington finally came to terms to reopen the government and extend the debt ceiling, markets will quickly turn their attention from the C-Span network to the Bloomberg terminals.

The politicians had their turn in the spotlight, now the focus will shift to the corporate sector.

Earnings season for the third quarter unofficially kicked off with Alcoa (AA) early last week, but with the DC fiscal follies stealing all the headlines, the aluminum maker got little attention.

If you happened to miss it, Alcoa did beat revenue and profit estimates and reaffirmed its growth target for the year.

But overall, expectations for Q3 results have been tempered, as analysts have once again set the bar on a low rung for corporate management to easily hurdle.  Companies in the S&P 500 are expected to expand profits by three percent and revenues are seen increasing by four percent, both measured against the previous year's results.

And while we’re still in the early stages of reporting season, the pace has been set by some of the big heavyweights in the financial sector (JPM, WFC, C, BAC) and in the consumer staples sector (JNJ, KO, PEP).

Together they indeed paint an early picture that results will once again be lackluster, yet good enough to probably set another all-time record high for corporate profits.  And it should come as no surprise that the S&P 500 index is also on the verge of setting yet another new record high.

But aside from the large-cap bell weathers that generally project the direction and health of the economy, earnings season is a great time for traders too.

It comes around four times a year, and with it come some of the biggest price movements for individual stocks.

And for traders looking for huge profit potential, earnings season means plenty of opportunity.

Very soon, the high flying momentum stocks will report earnings results, and with them usually come some of the largest price swings of the year.

These stocks tend to discount the fundamentals and trade with valuations that are in the nose bleed seats.  With these types of stocks, it’s all about the expectation of explosive growth rather than profit performance in the near-term.

And because of these optimistic assumptions, price volatility and huge price swings usually occur around earnings events that can offer massive profit potential, whether you trade directly in the shares, or in the options markets like I often do.

Momentum stocks can be great trading vehicles, and because of all the volatility they generate, massive gains can be seen in a relatively short period of time.

You've probably heard of the some of these names.  Tesla Motors (TSLA), Linkedin (LNKD), Netflix (NFLX) and Amazon.com (AMZN) are a few of the popular noms du jour trading on Wall Street.

And all four companies are set to report earnings starting next week.

But of course trading in these stocks also comes with just as much risk too -- volatility indeed cuts both ways, and if you’re caught on the wrong side of the trade, it can be devastating.

That’s why risk management should always be a high priority for both traders and investors.

I tend to add another layer of control when I trade momentum oriented securities by defining my risk through various options strategies.

Momentum stocks can produce huge gapping price moves, so it’s always important to work within your individual framework of risk.

As a young floor trader, I was quickly taught a simple technique to help me gauge how big of a move was most probable ahead of an event like an earnings report.

It was essential as part of the process in managing risk as an options market maker.

And now as I’ve become an individual investor like you, the same technique is equally as useful to me when I trade securities going into an earnings event.

Knowing what the market expects in terms of the magnitude of a move is extremely useful.

That information can help me decide which strategy I care to implore.  And if I’m using options, it can even help me determine which strike prices I may want to buy or sell based on my profit and risk parameters.

So here’s how to find out what the market thinks the expected move off earnings may be:

If you can add two numbers together, then you can easily locate the implied move.  What we want to do is simply price the at-the-money straddle with the closest expiration date that captures the event.

A straddle is the simultaneous purchase (or sale) of a call option and a put option with the same strike price and the same expiration date.

And in our exercise, we want to locate the straddle that’s closest to the stock price which would represent the at-the-money straddle.

Essentially what we are doing is adding the value of that specific call option and put option together, and the sum represents the break evens around the strike price for the straddle.

And those break evens are also going to act as forces of resistance and support as the price action reacts to the earnings event.

The idea is that whatever equilibrium is set by the straddle price should translate to the range of a move in the underlying market.

This of course is not 100% accurate, but when gauging a projected move, pricing the straddle increases your forecast of how big of a move is most probable.

One final point is that this technique is to gauge magnitude and NOT direction.  Picking up or down will not be found by pricing the straddle, simply locating a key high and low point is the primary benefit of this technique.

Here’s a timely example that you can follow along and see how accurate the options market’s implied prediction turns out to be.

Chipotle Mexican Grill (CMG) is another momentum oriented stock.  The company reports earnings today after the market closes.  Analysts are expecting the company to earn $2.78 per share on $820 million in revenue.  The stock currently trades at 46 times profit estimates, which is triple the valuation of McDonalds (MCD).

The stock closed yesterday at 438.07 and, based on the price of the CMG October 440 straddle (nearest to at-the-money and expiration is the following day), the stock is likely to move roughly 7% or
29 points. 

That’s the price of the straddle ($29), which tells me that the market is pricing CMG to either be trading roughly at 470 on a positive move or roughly at 410 on a negative reaction.

CMG "hot points" are roughly 470 or 410 after today's earnings report...

Hasta luego!

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