Let’s pretend for a moment that I don’t know more than the market does …
I am of the school of thought that the sum of all known pricing factors at any given point in time is reflected in the stock price. So, if this is true, this makes trading on earnings a binary event.
New information is introduced to the market and price moves accordingly (up or down and usually quickly). If you have a directional trade on, you are most likely going to maximize your profit or lose most (if not all) of your capital.
So, why trade directionally on an earnings report if it’s a coin-flip trade. Just like any sort of bet at a racetrack, at a sports betting site, or at a casino, the bettor has odds and expected value. Now, if we could be paid to take on risk, a 50/50 proposition becomes very compelling.
Let’s look at Delta Airlines (DAL). They report earnings on January 20th before the market opens. Looking at the price chart, we see that it is in a bullish pattern with the 200- and 50-day moving averages positively sloped. Looking at past performance, we see that eight out of the last eight earnings reports have exceeded expectations with the stock ending the day in positive territory.
As well, one of DAL’s biggest costs is jet fuel, and we all know what the price of crude oil has done over the past few weeks. Using the at-the-money implied volatility, we calculate the market is pricing in approximately a 6% move through the January 23rd expiration, which targets the $48 level.
For the 1/23 expiration, the 46/48 call spread can be bought for $0.30. This would offer us a reward to risk ratio of 2.33:1!
So, let’s say just say that taking a long bet into DAL earnings is a 50/50 proposition (I have given you three distinct reasons why it is not) and you are being offered 2.33:1 to take this bet. If you want to be a successful options trader, there should be no question as to why you would not take this bet!
