Trading Earnings: Goldman Sachs Options Trading strategy
Why Use Options During Earnings Season
New and experienced investors alike often make the common mistake of buying a stock just ahead of it releasing its earnings report. They usually consider signs such as top-notch fundamentals, a compelling growth story, and a bullish setup for the stock. While investors have indeed been successful using this strategy, it can fail badly if the stock opens at a lower level than the previous day on earnings.
For instance, when investors bought shares of Domino’s Pizza (DPZ) ahead of its July 21, 2016 earnings report, the shares were in a bullish technical price pattern called a cup and handle. It turned out to be the right decision for the investors as shares gapped up on the news.
However, in the case of investors with Mobileye, the strategy didn’t work as shares crashed 8% on the day of its quarterly release. Investors were further rattled by the news that the company would be ending its relationship with Tesla. Share prices did not increase even though the company delivered a strong quarter of earnings and sales growth.
For using options during earnings season, investors have to look at stocks that are at or near proper buy points, with most of these building bases. They should subsequently look for a slightly out of the money monthly or weekly call option. In other words, the strike price should be above the underlying stock price. Strike prices usually include a premium as the cost of the option.
Investors should then divide the premium by the stock price, subsequently multiplying it by 100. This will give them the percentage downside risk for a particular trade. They should always look for trades with a downside risk of at least four percent or less.
Two Basic Options Strategies
Ride a price move without getting hurt by volatility: IBD introduced an options strategy to limit risk around earnings in 2016. It involves capitalizing on a stock’s upside potential when it moves around earnings. This reduces the risk of it natively reacting to an earnings report. Investors can use either monthly or weekly options, as long as the cost of the option is satisfactory.
IBD weekly’s May 9th, 2016 edition featured Nvidia. It got support at the ten-week moving average. On May 12th, the shares were trading around 35.50. On May 13th, a slightly out of the money weekly option having a strike price of 36 had a premium of $1.27. The trade had a 3.6% downside risk.
Investors could exercise the option at 36 on that day. The price of shares on May 13th increased to 40.98. An investor can sell the option for a nice profit on the day if he/she didn’t want shares.
Investors should realize that the likelihood of success in earning option plays isn’t 100%. However, compared to purchasing a stock ahead of its earnings, options provide a lower-risk alternative as the risk is predefined.
Earn from Potential volatility: Investors can take advantage of extreme moves when markets panic and volatility increases. They can also hedge their existing positions against any severe losses. When volatility is high for both the specific stock and the broader market, Traders who have a bearish outlook on the stock can purchase puts on it.
For instance, Netflix (NFLX) experienced a 20% decline year to date on January 29th, 2016, closing at $91.15. This was from more than doubling in 2015, performing the best on the S&P 500 of that year. Bearish traders can buy a put at the strike price of $90. The stock was expiring in June 2016. The put had an implied volatility of 53% and was worth $11.40. In other words, Netflix would have to decline by 14% or $12.55 before the put becomes profitable.
Goldman Sachs Options Advice
On the question of whether a stock’s price will rise based on its earnings results, Goldman Sachs as an experienced investment service has some valuable advice for investors. Goldman Sachs’ Options team, after conducting a long-term study of pre and post-earnings behavior, found that most underperforming stocks in the two weeks ahead of the event reacted positively on earnings day. They noticed that stocks tend to rise after reporting earnings. Thus, a basic options strategy of buying calls on all stocks set to report can prove profitable for investors.
Strategists John Marshall and Katherine Fogertey in a report opined that underperforming stocks ahead of their earnings profited 18 percent on average. This was 4 percent higher than what they would’ve got without the filter.
As an explanation of the trend, Goldman Sachs opines that to avoid risk, investors can reduce stock positions ahead of an event. They reinvest in the stock once the uncertainties of the report diminish. The stocks get a stronger and positive reaction on earnings as those stocks have lower expectations.
David Seaburg who is the head of equity sales trading at Cowen and Co. also believes that this explanation fits the scenario. According to him, massive pressure because of fear and downside sell-offs can dislocate any brand. He also observes that the expectations are already compressed and super-low as we head into an earnings cycle. Thus, investors should always look to buy call options of significantly declined stock, head of their reported earnings, as it gives them a massive profit potential and the chance to earn big.