An important thing to remember is that my approach to directional trades is different when going into an earnings release cycle, rather than when outside of the earnings cycle.
Outside of the earnings cycle, other factors trigger my entries. Those factors could be fundamental in nature, or they might be based on unusual options activity. Most of the time, however, my entry is based on a technical trigger, which might well be a combination of these factors.
An earnings play is much different and, at times, it is easy for my students to confuse the rationale for entry. A directional earnings play is not an endorsement (in a bullish signal), nor a rejection (in a bearish play) of the fundamentals of a given company. Keep in mind, fundamentals are a part of the analysis, but they are not the determining factor.
Choosing an entry comes down to two things –1) Risk/reward scenario and 2) How plausible is the reward to risk scenario?
First, I look at the price chart to discern any major trends. Typically, it doesn’t bode well to try and buck a major trend without some solid evidence to back that up.
Next, I look at the previous earnings performance. For whatever reason, some equities perform better than analysts’ expectations, some worse. It is not a reason to enter into a directional signal, but one that cannot be ignored. I look at the equity’s peers. Am I seeing a distinct pattern in the sector that I may be attempting to fade? If so, I need other strong evidence to confirm my convictions.
Finally, I take the average performance and implied volatility measured move to determine a targeted strike level. Given the reward to risk of the identified scenarios, I use all the above inputs to determine if I am being paid commensurate to my risk.
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