Speculating on Earnings with Options in a Separate Account - Educational

Although many misunderstand options trading and consider it too "risky", it is actually a way to trade smarter, defining your risk and utilizing strategies to win in markets trending higher, lower, or sideways. The flexibility of options allows for larger gains, better risk management, and can supplement any equity portfolio, even if just looking to go 20% into option positions.

However, I feel that there is a time and place for pure speculation, especially when it comes to earnings.

Understand, anyone that tells you that he/she can predict where a stock is going after earnings by looking at the chart and/or analyzing the fundamentals is selling you a lie, as there is no certainty to earnings. Many also rely on Sell-Side research, which tends to be way behind the curve, when deciding on earnings trades.

Options can be utilized to create high probability earnings trades, and often look to trade the magnitude of the move (volatility), more than the direction.

With that said, there is a way to give yourself an edge when trading options into earnings, and I will lay out some of the key factors to analyze when making a directional options trade into earnings:

1- Options Flow - Analyzing options flow is one of the key factors I look at when making a directional options trade for earnings. You are basically following in high dollar trades who are assumed to have much better information heading into earnings. Obviously we can not all be experts on every company, but those that do focus time consuming research are willing to bet big, so let them do the work for you and ride-along for the profits. Services such as mine at OptionsHawk.com constantly is looking for unusual and high impact options trades into earnings, and I often consider the action 5,4, and 3 days ahead of earnings more important than the action seen just ahead of the report, because those that spend the time doing the research will get in ahead of the Institutional money moving the equity in a pre-earnings run-up or run-down.

2- Fundamentals and Short Float - I prefer to be involved long in names are fair or cheap valuation and short in names at rich valuation, although you have to consider earnings momentum more than the metrics themselves. Look for companies with 20% or greater EPS growth forecasted for the following year, and building momentum in Q/Q sales growth. Also, I prefer companies with operating margins on the rise, and will also observe seasonal stock trends. I will read into the Sell-Side research just to get a better in depth view of how the channel checks are looking, and other important trends in key metrics. A stock with a high short float can result in much bigger moves, always key for options trades.

3 - Technical Analysis - I will gave the chart a thorough look for signs of accumulation or distribution, also mainly use technical analysis for target levels, stop levels, projected moves, etc. rather than a buy/sell signal. The chart enhances the first two factors and can determine the strike prices and/or strategy to use.

All this aside, even if the options flow is very bullish/bearish, there could be some inside info or thorough research that is spot-on, but a stock's reaction can even be more uncertain than the numbers. Many stocks will post what look to be fantastic results, but trade lower, whether it is from profit taking, or a lack of new interested buyers if the numbers are not eye-popping, and the same goes for earnings misses, where a stock could trade higher because it is simply too cheap, or expectations were low. Expectations into results play a key role in the stock's reaction.

Sometimes making a call into earnings is very tough, so only take the one's where all the analysis points to the same outcome, and follow your gut when it really comes down to it.

Side Note: You do not always need to trade earnings before the results, and can wait for the numbers. If you have positive signals from all the above factors and wait on the actual numbers to confirm, you can participate after hours in stock, or wait until the next trading session to play options, basing your expected move on the options flow and technical analysis already performed.

Now, with the speculating part of this means that it is best to set up a separate account, strictly for this type of trading. This account should be an amount that you can afford to lose while note taking a large hit to your overall portfolio. If you set aside $20,000 and make $8,000 in a quarter, book those profits and reset the portfolio back to $20,000 for the next quarter. Keep it small, around $2,500 per play and build it out as you hopefully make profits.

Last quarter I did this with a $10,000 account and closed Q2 with $51,057, a 400% return.

Some of the big winners included:

* Fed-Ex (FDX) October $75 Puts for +$4,650 on 10 Contracts (+150%)

* Research in Motion (RIMM) September $30 Puts for +$7,035 on 15 Contracts (+213%)

* Ulta Salon (ULTA) September $60 Calls for +$4,740 on 12 Contracts (+155%)

* Aruba Networks (ARUN) September $20 Calls for +$3,600 on 30 Contracts (+160%)

* Green Mountain (GMCR) September $100 Calls for +$4,571 on 7 Contracts (+220%)

* Silicon Labs (SLAB) August $40 Puts for +$6,800 on 20 Contracts (+425%)


Overall there were about 50 trades, fair share of losers and small winners as well, but as long as you catch a few monster wins, you should come out ahead, and if not, it will hopefully prove to be a learning experience and can take another shot with a separate account down the road.