Editor’s Note: It’s a trader’s favorite season… earnings season.
Every day, companies from every corner of the market are reporting their earnings from the second quarter.
Chief Income Strategist Marc Lichtenfeld has written before about the immense power that an earnings announcement has to affect a company’s stock price for better or for worse…
So today, we’d like to kick off this earnings season with a special message from our good friend Bryan Bottarelli, Head Trade Tactician at Monument Traders Alliance.
Below, Bryan will share one of his favorite strategies for profiting no matter which way a company’s stock price moves in the wake of an earnings announcement.
– Mable Buchanan, Managing Editor
Earnings reactions are often the largest single-day moves a stock makes all year.
I’m not talking about penny stocks, either.
Just look at the one-day movements of these big-name, multibillion-dollar market cap stocks:
- GameStop (NYSE: GME): up 33%
- Netflix (Nasdaq: NFLX): up 16%
- Dillard’s (NYSE: DDS): up 22%
- Smith & Wesson (Nasdaq: SWBI): up 17%.
These were all one-day price changes from the first half of 2021!
Earnings season is precisely when you want to be plugged into the market – because it’s when the real money is made.
In The War Room, we use what’s called an earnings strangle to make the most of this time of year.
How It Works
An earnings strangle is initiated by simultaneously buying an out-of-the-money call option and an out-of-the-money put option. This establishes a position with (theoretically) unlimited profit potential on the upside while limiting any downside losses to a predetermined amount.
The goal is to profit off a big earnings reaction in either direction – up or down. When executed correctly, traders can profit off a sizable price movement without knowing which direction it will be in.
A Real-Life Example
Let’s say Caterpillar (NYSE: CAT) stock is trading for $210 and the company is scheduled to report earnings on August 15.
You could establish a $3 earnings strangle by buying the following options…
- Caterpillar August $211 calls expiring on August 20 for $1.50
- Caterpillar August $209 puts expiring on April 20 for $1.50.
Prior to the earnings release, you won’t know whether Caterpillar will beat earnings or disappoint. However, you do know that as long as the stock moves at least 5% on earnings day – up or down – you will turn a profit on your strangle position.
Let’s say Caterpillar surprises with strong earnings and the stock jumps from $210 to $227 – an 8.1% gain. In turn, your calls gain 367%, while your puts expire worthless.
Altogether, your total trade moves up $7, good for a 133% profit. That’s because the substantial gain from the calls far outweighs the small loss from the puts.
Alternatively, if Caterpillar disappoints with weaker-than-expected earnings numbers and the stock falls below $210, as long as it falls at least 5%, you also make money on your trade!
In the first two quarters of 2021, the following companies had an earnings reaction of more than 5%…
And this is just a sample. There are dozens more!
All of them would be winners with the earnings strangle strategy!
Earnings strangles have distinct advantages…
- You know the exact timing of every trade ahead of time. Every earnings announcement is scheduled in advance, allowing you to plan your entry and exit orders accordingly. This way, you’ll never miss a trade.
- You have zero directional risk. While most traders look to predict the direction of a stock’s post-earnings move, this strategy removes all of the guesswork. When you play both directions together, all you care about is the magnitude (again, not the direction) of the move. In the example above, if the stock moves 5% (or more) on earnings day, you win – regardless of whether that move is up or down.
- You don’t need to act fast or trade quickly to get the best price. As long as the stock reacts enough to move the needle, the gains will be sustained throughout the session on earnings day.
- You can manage and allocate your capital more efficiently. Because you know the buy and sell dates in advance, you can anticipate what will be tied up in the market versus what will be available in cash. This way, you’ll know how much to put into each trade.
In our experience, strangles are consistently the most profitable trading strategy around an earnings report.