Using Volatility with earnings

OK now many of you know my feelings about earnings trading is that it is as close to gambling as you can get while trading. Well I am going to show you a technique I use to trade earnings using volatility to my advantage.

Earnings season comes but four times per year, check out www.earnings.com to find out when specific stocks are announcing their earnings for each quarter. You need to plan ahead for this strategy. This will be a straight call play, played two to four weeks prior to earnings.

First good fundamentally sound stocks usually have a runup (a small bull trend) just prior to an earnings announcement. This is a typical trend - it does not always hold true but it is a trend, however in our play it will not matter as long as the stock does not drop a lot prior to earnings. So the first step is to find good stock with good fundamentals. There are many screeners out there to find such a stock I use the one at Income Trader or you can use the screener at Options Xpress or Yahoo has a screener. The one from Income Trader is definitely for beginners because you need to know nothing about fundamentals to use it. It basically says Good Stock. Look through the “good stock” list and find one or two in a bull trend.

Second, You can look at the technicals of Slow Stochastics and MACD as well as support and resistance to determine where you think the stock is headed. Preferably up!

Third look at the Volatility chart for the stock and compare the current or implied volaility to the historic volatility. Now as you can imagine earnings is a time in which the stock price can change dramatically so the implied volatility is going to go up the closer to earnings you get. What we want to see, 2 to 4 weeks prior to earnings, is an implied volatility at or below the historic volatility. If it is already above the historic volatility, then we are already too late as the volatility is already priced into the options. Remember we want to buy low and sell high with volatility.

Fourth choose your option. As a conservative trader I choose the option strike at one step in the money. For example if the stock was trading at $53, I choose the call option at a strike of $50, the first in the money option strike. If you have an extremely small account you can choose out of the money options however there is more risk involved with those as there is no intrinsic value, meaning it is easier to have a 100% loss.

Then if you have timed your technicals correct looking at the stock graph and the volatiltiy graph, the option price should increase with the stock price (intrinsic value)but more importantly the option should increase the closer you get to earnings because of the increase in volatility (part of time value). Close the trade a day or two before earnings.

Lastly, I will use a trailing stop on these because many times news will come out a day or two before earnings suggesting that the company is expected not to make earnings. Also many investors pull their money a day or two prior to earnings to avoid any bad news caused by earnings and to take profits from the small run up, this causes the stock to drop in price.

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