By Nic Chahine
Here is the statement that always spurs heated debates:
"Investing going into a company's earnings report is gambling!"
Traders cannot predict how the markets will react to earnings reports regardless if the quarter is a miss, meet or beat with raised or lowered guidance.
Analysts may be able to nail the numbers spot on but they can't tell you how the markets will interpret the results. Traders sold Google (NASDAQ: GOOG) at one point because of the word count of their CEO.
This doesn't mean that traders should stay completely shut out of earnings events. Thanks to the option chains, traders can still participate in the earnings with lotto style trades. Those are trades with minimal costs, well-defined risks and a decent return when they hit.
A good candidate for such lotto earnings trades is crowd favorite Lululemon (NASDAQ: LULU), the so-called yoga pants maker. The products are pricey, yet have a cult following. Some of the stores don't even have the name on the building, just the logo. They are to yoga pants what Apple (NASDAQ: AAPL) was to the music industry.
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Lululemon reports earnings before the market opens on September 12. It is still too early to pick a stance on the stock, but traders can start working on the set up. The one-year chart below clearly shows why lotto trades in Lululemon have a good chance of working well. Those who guess the direction correctly can collect a pretty penny.
Meanwhile, here are a few points of contention to consider before trading earnings lotto style:
A good earnings lotto trade includes:
- A stock with violent reactions to earnings releases
- A stock with weekly options (though not a requisite)
- A stock that has decent options volume
- Defined risk usually nothing more than the price of the option position
- The direction decision: this is the coin flip moment! Traders have one chance at calling it right.
- One can go with the flow and take the same position as the market expectations
- Once can go against the grain and take a contrarian position to market expectations
- One can also pull a Constanza: make the decision and then take the opposite direction (it recently worked for me on CRM earnings)
The magnitude of the move: Equally as important as guessing the direction of the move is guessing its magnitude. It pays nothing to correctly guess that Lululemon will fall on earnings, but choose a trade that is so far out of the money that it won't participate in any meaningful options premium appreciation after the move.
Recap: to hit the earnings lotto trade with a proven earnings mover, traders need to guess up or down (that's a 50/50 chance). Although traders need to also choose a good level, the chances for success are still darn close to 50 percent.
A skeptic might ask: "why would investors not want to buy a real lotto ticket instead and have a chance at millions?" The answer is simple: a 50 percent (ish) chance of loss (here) is way better than 99.99999 percent chance of loss with a 'real' lotto ticket.
Nicolas Chahine is a former CFO for a successful web startup. He now manages his own fund, which is built around his credit-spread trading strategy. He is the mind behind the "[Mastering Credit Spreads]" online course and "[Create Income with Credit Spreads]" newsletter on Marketfy.com.