Approaching Earnings Setups With a Plan
Positive earnings results are poised to snap the broader equity market losing streak this month.
With a huge number of string earnings reports released already this quarter many traders are becoming intrigued by setups ahead of earnings. However, many fail to realize that there are special considerations you need to make when trading earnings.
When earnings are released, stocks can see very high levels of volatility, meaning holding a position in the underlying stock can be very risky.
Below is a step by step plan to approach earnings setups. You can apply some of these concepts to other catalyst setups, but this plan is specifically for trading ahead of quarterly earnings releases.
The Earnings Trading Plan
The plan has a number of steps that are meant to help you break down the setup ahead of earnings and make an informed trade selection.
This plan helps you evaluate and trade earnings setups in a systematic and methodical way. The steps in the plan are:
- Historical movement: Calculate a stocks earnings movement magnitude and direction for the last 8 quarters
- Implied Movement: Use the at the money straddle to calculate the movement being priced into the market
- Measured Move Target: Use the implied move to calculate an upside and downside target
- Chart: Look at the chart setup and determine if the stock is in bullish or bearish territory
- Risk and Reward: Find a trade setup with a good reward to risk ratio
- Breakeven: Calculate breakeven in the position
- Time and Target: Know what your holding period and profit targets are
This might seem like a lot of steps but using this plan will help you with a more focused approach to earnings trades.
Using a methodical plan like this will also help you avoid some of the weaker setups.
Putting the Plan in Action
Earnings season can get very busy. There are some days when over 100 stocks will report earnings, so it’s important to choose setups carefully.
Let’s look at an example setup below.
Stock XYZ is reporting earnings tomorrow and is trading around $100.
First you need to calculate its historical movement on earnings. This can be done manually, or
you can find this information from a number of free sources online.
In the case of XYZ, you find out that the stock has rallied 6 times in the past 8 quarters on earnings day, with an average move of 8%. You can see that there is a clear bullish bias here.
Next, you compare this to the implied move. You see that the weekly at the money straddle is trading at $7.50.
This implies a 7.5% move by options expiry ($7.50/$100). You can see now that based on historical movement, this is a reasonable expectation.
Using this implied move, you develop targets:
Upside target = $100 + $7.50 = $107.50
Downside target = $100 – $7.50 = $92.50
With these targets in mind, look at the chart. Since the stock usually goes up after the earnings report, you’re looking for the chart to confirm the stock is currently in bullish territory. If it’s not, move on to a different setup.
After you confirm the chart setup, it’s time to pick a trade using the upside target you calculated.
At this point, make sure the trade has a solid reward-to-risk ratio and a breakeven point that lines up with the implied move.
Once a trade is selected, you need to develop an exit price and plan. How you do this will depend on the options strategy you chose.
Using a Systematic Approach
Trading through earnings season can be overwhelming, but by using the plan above you can approach the task with a systematic approach.
I will go more into detail on the details of each step in the plan in further issues. For now, start thinking about your earnings trades this way.
You’ll be glad you did once you realize this can help you make profitable trades from earnings reports.
AKA, “The Alpha Shark”