Alcoa (NYSE:AA) officially kicked off earnings season for most people last week. The big action starts this morning though as the big banks start to report. The season will run for another 3 weeks or so, or at least that is what the headlines will tell you.
In fact there are companies that report their earnings nearly everyday. Not just the four weeks after Alcoa. If you are an active trader or portfolio manager you already know this. I take an in depth look at at least 2 names every day. And when I look at the calendar to see who is reporting it all boils down to the P’s and E’s.
Those of you that know me just did a double take. Yes I have a CFA designation, but I really do not use it for trading. But I do look at the P’s and E’s. Only that does not stand for Price and Earnings. Instead it stands for the two types of activity to pursue around an earnings report: Protecting, or Exploiting. Let’s tackle Protecting today and leave Exploiting for tomorrow.
Countless times I’ve heard traders talk about taking off a position for earnings. Since it is a volatile event the stock can move sharply if the report is not fully discounted. A surprise. That means you can lose a lot on a stock that has high volatility. So the trader thesis is to just avoid it. Seems very funny to me to have this attitude. First volatility means that if you can lose a lot, say 10%, then you could also be the beneficiary of a 10% move to the upside. This alone should make the short term trader interested.
What you need is protection for the event. The problem lies in the potential for a gap move. The stock might move that full 10% (or more) all in one trade. If that happens then your stop loss that was set 2% below was triggered, but you sold down 10%. Ouch. That is if you even had your stop set to trigger after hours or before the open when companies report. Many brokers do not offer this trade type. This type of unprotected risk is what most traders quote as the reason to avoid holding through an earnings report.
But the really odd thing about this stance and behavior is that there are tools to protect your position through the report. The options market has been around for decades. And it allows you the capability to tailor your protection to your position. What is more it gives you this option with defined risk. As an owner of protection you cannot lose more than you pay, and there is no gap risk. Sounds pretty good huh?
If you own a stock, like JPMorgan Chase & Co (NYSE:JPM) that reported Tuesday morning, you can protect it using options in a number of ways. the simplest is buying at the money puts. This put option, or right to sell at a specific price, will move nearly penny for penny with the stock price to the downside. So if the stock falls $1 then the put options should gain close to $1.
There are many variations on the protection trade. If the at the money put options are too expensive you can also sell covered calls to lower the cost. This combination is known as a collar. The thought there is if you end up getting called away it is at a higher price that you are comfortable selling the stock. If the cost is still to high you could also spread the puts. That is sell a lower strike, out of the money put, at a strike at or below where you think the stock has a risk to fall to on the earnings report. This limits your downside protection but also lowers the cost again.
Disclaimer: The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.