Anticipation for earnings results can drive stock prices up or down ahead of the scheduled release date. Both Fear and Greed, the two driving factors behind the stock market, can cause a price to fluctuate wildly as investors second guess whether the company will meet, exceed or fall short of expectations. But while there is a lot of uncertainty about what the results will be, there are some given facts about how the market will react. In this article, we will discuss our #1 strategy for making money from stocks during earnings releases.
Profit for the Shareholders
The sole goal and objective of a company is to make a profit for its shareholders. The company lists on the stock exchange to raise capital, for many various reasons, but primarily to expand their business. Whether that is through acquisitions, product development and expansion or through marketing.
Being a listed stock on the exchange, the company must meet certain obligations. These include disclosing market sensitive information and reporting regularly on their performance results. To help ensure their stock price does not fluctuate wildly, the company will provide a guidance to how they expect to perform during the upcoming time-frame (quarterly, half-yearly or annually).
Providing a guidance will cause the share price to rise or fall. Investors will push the price to where they perceive the earnings expectations matches a ‘fair value’ for the stock. Then, during the time before the scheduled earnings announcement, the stock price will fluctuate according to the many other influences (such as geopolitical activity, broader economic influence, other company announcements, industry developments, just to name a few).
As the time drawers closer to the scheduled earnings date, uncertainty towards actual results increases. News headlines will tout reasons for and against why the company will meet, exceed or miss the targeted levels. Of course, no-one knows what the actual results will be. All statements or reviews about the upcoming results are speculative expectations.
When earnings results are released, the stock price reacts. Quite often the share price can gap up or down, especially if the results have been released before market open or after market close. The pent up fear or greed will drive the share price in reaction to the results. In time, the share price settles (and this at times might take days), before it then resumes whatever trend investors now perceive the company to be in.
No-one knows what the results of the earnings report will be. Well, there are ‘insiders’ who are privy to the information, but these people are governed by law not to disclose or benefit from this information ahead of the market release. Despite the fact that none of us (in the real investing world) have a 100% absolute expectation of how the company has performed economically, there are some key concepts that are.
Firstly, Time will decay. This is an absolute that influences the markets daily. It’s a given, like death and taxes! Secondly, uncertainty increases ahead of the earnings results. For some stocks, this uncertainty builds exceptionally high, while for others it is a mild influence. When uncertainty is very high, this is negated the instant the earnings report is released and the market reacts.
Butterfly Option Strategy
When it comes to benefiting from the uncertainty surrounding an earnings result, we use an option strategy referred to as the Butterfly. It is so called because the payoff diagram depicts the image of a Butterfly – as per the following image.
The peak of the line represents maximum potential profit and is referred to as the body of the Butterfly, with the outer wings representing the maximum loss zones.
Reading this uncertainty is achieved through Implied Volatility (IV) – which estimates the unpredictability of a securities price. IV increases when the market is bearish, or falling. While IV decreases when the market is bullish, or positive.
Option pricing provides us with an ability to define whether or not the IV for a company scheduled for earnings is high or low. If it is very high, then historical performance shows us that IV will decrease once the earnings results are known, and that uncertainty factor has been negated.
Take a look at the following chart for Expedia.com (EXPE.US). The blue line below the chart depicts IV. The dramatic drop in IV has occurred on each earnings report. There are 5 examples in this chart, spanning 15-months. By using the Butterfly strategy, we have the potential to make a profitable trade based purely around this fall in Implied Volatility.
But what are the Risks?
As with every strategy, there are Risks to trading. For this approach to the Butterfly strategy, the risk is that the share price gaps outside the butterfly wings. That is, gaps outside the maximum loss levels. The maximum loss for this trade is how much you put down on the position. Therefore, you only have at Risk as much as you are willing to invest in the position.
There are a number of key factors we look for in approaching entry into this strategy which is beyond the scope of this article. The Butterfly is an advanced approach to trading and if undertaking yourself, requires an advanced knowledge of option pricing.
At AIE, we have a subscription service where we provide recommendations for this strategy. If you would like to know more, please contact us. If you would like to receive free trade recommendations please click here.
Uncertainty ahead of Earnings Announcement
Many investors are fearful of the uncertainty that builds up ahead of a company’s earnings announcement. The speculative nature of whether or not the share price will react positively or negatively means an investor is left at the mercy of not being able to adopt a strategy suitable to the conditions. But by knowing there are strategies available that focus in on these particular events, the investor can diversify their portfolio in an effort to reduce risk.
Matthew Brown – US Stocks & Options specialist
US Equity & Option Client Advisor
Halifax Investment Services
ASIC Australian Financial Services License Number – 225973
Matthew is an Authorised Representative of Halifax Investment Services (Halifax). Halifax provides broker services, including Full Service and Discount Services using multiple trading platforms.