The Trick To Maximizing Your Returns This Earnings Season

The Trick To Maximizing Your Returns This Earnings Season
Carl Hazeley

about 3 years ago3 mins

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What’s going on here?

This week marks the start of another earnings season, with companies beginning to reveal how they performed in the fourth quarter and therefore across 2020 overall. As investors reassess their portfolios, buying and selling stocks in response to fresh information, large share price swings aren’t uncommon – and an options-based trading strategy could help you make money from those moves.

What does this mean?

This strategy is a “tactical” one, meaning it’s focused on maximizing short-term profits over long-term returns. With that comes increased risk, so you’d be wise to think of tactical trades as a way to invest excess cash rather than draining your future-focused portfolio to try them. With that in mind, here’s what you need to know:

1️⃣ Investment strategies involving options currently appear attractive. Analyzing investors’ buying and selling of options provides clues as to how far share prices will move when companies report earnings. And options are currently implying an average earnings-day move of 4.3% for American S&P 500 stocks: the smallest in years. When “implied volatility” is low, as it is now, options typically cost less – and are therefore more attractive.

2️⃣ Investment flows into US stocks suggest prices should be higher. According to a mathematical model drawn up by investment bank Goldman Sachs, the amount of money moving into Stateside shares over the last three months indicates the S&P 500 index is sitting some 10% lower than it should be. As investors get back from holiday and back to business, that gap is still yet to close.

Goldman’s flow model says the S&P 500 should be 10% higher
Goldman’s flow model says the S&P 500 should be 10% higher

3️⃣ Analysts might be too pessimistic. Despite kicking off each of the last eight years by predicting around 9% annual returns for US stocks, the average analyst currently expects the S&P 500 to end 2021 only 5% higher.

💡 And therein lies the opportunity: investors buying options on S&P 500 stocks now will be hoping that firms announce stronger-than-expected annual results for 2020 (as they usually do) and reveal earnings forecasts for 2021 that are also higher than anticipated. All else equal, companies that do should see their share prices rise – leaving holders of their stock options “in the money”.

Why should I care?

For a small upfront fee, “call option” holders get the right to buy a stock at a future date for a predetermined price. Alternatively, you can sell the option on before then and lock in a profit, with the most you stand to lose the initial premium paid.

Buying call options ahead of earnings has proved to be a profitable strategy for the last three quarters. And with coronavirus vaccines making their way around the world this earnings season, companies might be encouraged to post particularly optimistic annual forecasts – meaning option-buying could prove even more rewarding than usual.

Buying options right ahead of earnings releases and selling them right after returns 12% on average
Buying options right ahead of earnings releases and selling them right after returns 12% on average

But buyer beware: volatility can rapidly rise, making previously cheap-looking options more expensive. What’s more, the average returns shown above don’t include any transaction costs (or tax). It’s therefore worth checking your brokerage account in advance to see how much the fees involved in actioning any options plan will eat into your potential profit.

If you are interested in putting this strategy into action, however, then the table below shows companies where Goldman Sachs’ own analysts hold the most out-of-consensus estimates for the coming quarter – and expect shares to move most significantly as a result.

Source: Goldman Sachs
Source: Goldman Sachs
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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