A Time-Tested Options Strategy that Doubles the Market

How do stocks respond to earnings?

Obviously, some rise and some fall. It depends on their numbers and their guidance.

But history shows there are more "beats" than "meets" and "misses."

Source: Bespoke Investment Group

The last couple years, part of the high probability of beats is attributable to what legendary hedge fund manager David Einhorn calls the game of "beat and lower." (It used to be "beat and raise.") Meaning, companies lower the bar, to beat the bar.

Notice the orange bar all the way to the right. This quarter’s earnings beats are on pace to set an 11-year high.

Whether it’s "beat and lower" or "beat and raise," companies have been consistently topping earnings estimates for some time. Quarterly earnings beats haven’t dipped below 50% dating all the way back to 1999. And beats have averaged close to 63% over the full range in the chart above.

It shouldn’t be shocking that global investing powerhouse Goldman Sachs (GS) has already studied this phenomenon.

The firm concluded, after two decades’ worth of research on long-term earnings effects, that stocks increase an average of +0.7% following earnings.

I know … an average gain of less than +1% doesn’t sound like much to sink your teeth into. But, with gobs of companies reporting earnings, those small gains can add up quickly.

Naturally, Goldman Sachs, who was long $54 billion — and short another $47 billion — of derivatives at the end of last year has a more-effective tool to capitalize on this approach:

Add an options component to the mix.

If the average stock rises in price based on earnings, the related calls move higher in tandem.

The results of their study, conducted from 12/31/1996 to 12/31/2015, is why the company has long recommended buying call options on stocks before their companies report earnings.

Goldman’s options research group reports the strategy of buying at-the-money, one-month-out calls across the board has produced an average gain of +14% (excluding transaction costs) over the 19 years studied. (It was profitable every year, too.)

In contrast, the S&P 500 achieved a +7.4% annualized return over the same period (with four down years along the way: -9.1% (2000), -11.9% (2001), -22.1% (2002) and -37% (2008).

Can options trading really be this simple?

The data dictates that it can be.

Last week was busy with about 20% of the market reporting …

Source: Earnings Whispers

Let’s walk through an example …

If you bought shares of Amazon stock the day before its earnings beat on April 27, you could have sold at a maximum profit of about +4% the following day. (Buy pre-earnings; sell post-earnings.)

But, if you bought at-the-money, one-month-out AMZN calls instead, you could have racked up a one-day gain of +38% using the options approach.

That’s all looking through the rear-view mirror. Peak earnings are behind us right now …

Going forward, FactSet thinks earnings will continue to have a strong 2017. The research firm predicts we will see the first year-over-year double-digit earnings increase since 2011 for S&P 500 companies this year.

Focus on the months of January, April, July and October if you’re interested in employing this options strategy. The bulk of public companies report their quarterly earnings early- to mid-month in the months after standard quarters end.

And make sure you have access to a low-cost options broker!

Best,
Grant Wasylik

Originally from Pennsylvania, Grant graduated from Juniata College with an economics major and accounting minor. Since graduation, Grant has worked in the investment industry for almost two decades by serving in various roles … Prior to coming to…