Learning the Earnings Cycle

Although there are thousands of options contracts changing hands on any given day, when is the best time to buy options?�

When it comes to investing your money, the answer truly is: It depends. There are no hard-and-fast rules for buying and selling options. However, a great time to find potentially profitable trading opportunities is in conjunction with publicly traded companies’ quarterly earnings reports.�

As a general rule, earnings reports affect short-term options traders who hold positions for a matter of weeks or days because earnings season focuses attention on very near-term goals.�

For active options traders, earnings season can be a time of both up- and downside volatility for particular stocks and/or sectors. The temporary dips or charges aren’t usually of concern to “buy-and-hold” investors. But because options only have a limited time to pay out, earnings reports can mean sudden profits or losses.�

Buying options, though, for earnings bets can be a much-less-expensive, less-risky way to test your hunches about the effects of earnings on a company.�

Publicly owned companies must, by law, report their earnings every three months. The four earnings seasons last approximately six weeks and begin in mid-January, mid-April, mid-July and mid-October. However, there are earnings announcements released practically every trading day of the year, but the aforementioned seasons are when news (good or bad) is most-plentiful.�

Wall Street analyzes mounds of data to create estimates for each company’s earnings, and it doesn’t like surprises. Investors can panic and sell for both negative and positive surprises, which can instantly lower premiums. The trick is knowing whether a discount premium is a flashing “buy” signal or a warning sign.�

If a company’s numbers don’t hit expectations, investors fear that the company’s future earnings will dwindle, which can send call premiums plummeting and put premiums soaring.�

It’s important to consider, though, whether a company has cyclical earnings. Oil, agricultural, retail and entertainment/leisure firms all have seasonally weak quarters, but Wall Street’s memory is short and it often forgets to compare apples to apples.�

If it’s simply a case of seasonal weakness, use Wall Street’s short-term memory loss to buy call options for companies that will see a seasonal earnings recovery in the upcoming quarters. For instance, if retailers aren’t doing very well during the summer months, going into the holiday shopping season you may want to choose specific names or invest in the sector itself through an Exchange-Traded Fund such as the Retail HOLDRs (RTH), which represents nearly 20 names in that industry.�

RTH is one of many optionable ETFs available to trade when you want to invest in an industry instead of a number of the individual names — this can not only save commission costs, but it could also protect you against “overweighting” your portfolio with too many names in one sector.�

Conversely, if a company greatly surpasses estimates, investors can also punish the stock by selling. It may seem counter-intuitive, but many investors worry that a blow-out report means the company has hit an earnings apex and will be unable to sustain such high numbers in upcoming quarters.�

Again, check to see whether the company has cyclical earnings or if it enjoyed an exceptional one-time boost from the sale of a holding or a new product launch, for example. If that’s the case, it’s likely that the next quarter’s earnings will also be strong, so it can pay to buy call options at a discount.�

Either way, it’s difficult for options traders to use earnings surprises to time the purchase or sale of options. What can be more successful is for options investors to use forward-looking information and forecasts from earnings reports to set up their longer-term options plays with LEAPS.�

Generally, establishing an options position at least three weeks prior to an earnings announcement will ensure you get in before any pre-announcement news potentially inflates the options premium.�

Knowing when to sell, however, is a bit trickier.�

If an option’s value suddenly plummets after an earnings announcement, the amount of time left before expirations will be the key to determining your next move. If there’s at least three months until expiration, you may benefit from holding the option to see whether it will recover. Otherwise, you may be better-served to bail out of a losing position to quell losses and recoup any remaining value while it still exists.�

Earnings season can bring a bevy of buying opportunities, as well as discount delusions — just remember that a good deal isn’t always a good deal. Be sure to look at the time premium available for each option and take advantage of a company’s earnings forecasts for upcoming quarters.