Most of my trades coincide with publication of earnings, “earnings plays”, in the jargon of traders. I do so because those quarterly announcements are the only time I can guarantee heightened interest in stocks and their options, and therefore a likelihood that something will happen to provide me with an opportunity for profit. There is nothing worse than entering a position and seeing it immediately drift into the doldrums, where time passes and nothing happens.
Over years of trading I have settled on a few vehicles that best serve my needs.
When trading options, I use the short iron fly when I don’t know which way the price will move, or sometimes an iron condor if the options grid makes for a more balanced structure. When I expect the stock price to move in a direction, up or down, I use a short vertical position, a bull put spread for a rising price or a bear call spread for a falling one.
In analyzing potential positions I’m attempting to answer several questions.
- Is the stock or option liquid, both in terms of average volume of shares or open interest on options and the narrowness of the bid/ask spread. The higher the volume or open interest and the narrower the spread, the more liquid the trade. For the bid/ask spread, I want 10% or less for the iron fly and 25% or less for the iron condor or vertical structures. For shares, I want no more than a 1% spread.
- Does the trade have value? The question is easier to answer in the case of options, whose value relies on implied volatility. I look at the IV as a percentile of both the range for the past 12 months and of the most recent noticeable reversal in the IV trend as seen on a daily chart. I expect both to be in the 50th percentile or higher. In the case of shares, I don’t have a ready answer. I could demand a minimum price or some sort of fundamental attribute for the company, but it’s not something I systematically do.
- Is the stock trending? For this I look at an indicator called the Average Directional Index, or ADX. If the ADX is above 25, then the stock is trending. The ADX says nothing about the direction.
- What direction is the stock trending? For this I look at two directional indicators associated with the ADX, the +DI and the -DI. The +DI measures the strength of the upward movements, and the -DI of the downward movements. If the +DI is higher than the -DI, then the trend is up; if lower, then down. The breadth of the gap between the two indicators tells the strength of the trade. Options can be played with trends in either direction, or no trend at all. The no-fee brokerage I use for shares, Robinhood, doesn’t allow short-selling, and so I only play uptrends.
- To what extent is an earnings surprise likely? To answer this question, I turn to the analytical house Zacks, which has developed a tool called the Earnings Surprise Predictor to determine if the published earnings per share are likely to exceed or fall short of pre-earnings estimates by analysts (the Street estimate or the consensus estimate). See the note below, “About the ESP”. If the ESP is at or close to zero, then the likelihood of a surprise is small. The higher it is in either direction, the the greater the likelihood of a surprise. But there’s a wrinkle: The ESP is right 70% of the time about positive surprises, but the results are not greater than chance for negative ones. And the results for positive are better when the Zacks rank is bullish (1 or 2) or neutral (3). So when I play a negative surprise, I require a bearish rank and a fairly impressive negative surprise number of -5.00 or lower.
Those are the five questions. Once I have the answers, the rest of the analysis is easy.
I require liquidity and for options, value for all trades, Here’s how the last three questions apply to my trading.
Options bull play (bull put spread): Trending, upward direction, positive earnings surprise likely
Options bear play (bear call spread): Trending, downward direction, large downside earnings surprise likely
Options bi-directional play (iron fly or iron condor): Not trending, little directionality, earnings surprise unlikely
Shares: Trending, upward direction, positive earnings surprise likely
The questions are simple. Teasing out the answers for 5,000 stocks is a bit a three-ring-circus. I do it manually using a spreadsheet although I shall, at some point, write code that will automate the process.
To keep my analysis on track and to serve as a basis for my coding, I have put the process into an algorithm form that shows, step-by-step, what I do.
A note on the Zacks Earnings Surprise Predictor (ESP)
The ESP is derived from two other Zacks indicators, the Most Accurate Estimate and the Zacks Consensus Estimate. The comparison is looking for late revisions to analysts estimates, an indicator that the Street assessment of a company is changing. That’s what a surprise is, after all, a change in the assessment that has not yet become the conventional wisdom.
The Zacks guide to the ESP: https://www.zacks.com/stock/news/90676/zacks-earnings-esp-a-better-way-to-find-earnings-surprises
The Zacks guide to its estimate research (look for the “Most Recent Consensus Vs. Zacks Consensus section): https://www.zacks.com/help/est_research.php
The guide to Zacks rank: https://www.zacks.com/education/stock-education/zacks-rank-guide
By Tim Bovee, Portland, Oregon, November 27, 2017
Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.
No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.
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Based on a work at www.timbovee.com.