The Best Way to Play Earnings Ahead of the Election

Thankfully, the presidential election is almost here.

There’s a wealth of research out there documenting what happens to the markets immediately after a Republican or Democrat wins the White House, and what it means in the long term.

Conventional wisdom – and research by Yale Hirsch, in fact – suggests that no matter who wins the presidency, stocks tend to decline the first year after an election and then rise over the next three.

That is, until recently… markets went up after George H.W. Bush’s election in 1988, both of Bill Clinton’s wins, and Obama’s first win.

So with all this uncertainty, it’s no surprise that traders are having a tough time. And on top of that, we’re smack dab in the middle of earnings season…

So today, I want to show you a trading technique that should prove much more reliable than trying to play the outcome of the election.

Let’s get started…

Follow this “Four-for-Four Rule” to Set Your Trades

Since we’re still in the middle of third-quarter earnings season, it’s time to take a short break from the election and get back to the companies set to report their earnings per share and revenue numbers.

Here’s a look at the companies that are due to report earnings. This is from proprietary tools, but you can obtain this information from any financial site that tracks and reports earnings. Now let’s search for any strong patterns that could offer some profitable trading ideas…

What you want to look for are the stocks that have either a four-for-four record of positive earnings or a four-for-four record of negative earnings numbers.

Now in the list above, you’ll see that Mallinckrodt plc (NYSE: MNK) has beat its earnings in each of the past four earnings seasons. However, the movement of the stock following earnings is less impressive, as you can see in this chart:

So I’m going to highlight another stock with the same four-for-four record – but with a much better price movement – NVIDIA Corporation (NASDAQ: NVDA):

As you can see, NVDA has shown upward momentum in four of the four past earnings seasons.

Now given the high volatility we’re looking at through the end of next week, I wouldn’t suggest any short-term or weekly trades.  Ultimately, the risks simply outweigh any reward potential. But that doesn’t mean you can’t place trades that will expire much further away…

“Straddling” Volatile Markets for Unlimited Profit Potential

A straddle is one of the most popular methods traders use to profit during times of high volatility. It’s one of the easiest to execute – you simply buy a put and buy a call with the same strike price and expiration simultaneously on the same order ticket. This lets you capture profits on stock movements – whether to the upside or downside. And the best part is… your risk is limited, but your reward potential is unlimited.

Here’s an example of a straddle with a December expiration. But keep in mind that this isn’t an actual trade recommendation. I simply wanted to show you how this strategy works:

As you can see, in this scenario, you bought-to-open the December 16, 2016 $70 call at $4.35 and bought-to-open the December 16, 2016 $70 put at $4.68 for a total debit/risk of $9.03 (or $903 since one options contract is equals 100 shares).

The median percentage move over the last four earnings seasons is 13%.  If you tack on a 13% move to NVDA’s $69.00 stock price, that’d make for expected price move of $8.97. And if it moved that much by expiration, you’re basically $9.00 in-the-money (ITM).

The one thing you’ll want to pay close attention to is how long it takes for the stock to reach your profit target. You don’t necessarily want to wait until the expiration date to exit this trade because you’d end up only collecting a $0.03 profit, which is essentially breaking even on the trade. If the stock moves in your favor well before expiration, then you’ll be able to collect your profits through the premiums. But waiting until expiration to basically break even might not be worth your time.

So another consideration in this event would be to look for a cheaper straddle with a shorter expiration date. You could also consider a “strangle,” which is basically the same thing as a straddle (you buy a lower-strike put and a higher-strike call with the same expiration simultaneously on the same order ticket.

Your other option in this scenario is to wait to see if NVDA ends up beating earnings expectations for a fifth season in a row. If it does, you could look at long call options on the stock. If it doesn’t, then it might just be time to move on to the next stock.

While the recent pre-election market trends make it harder to ascertain what will happen, one thing IS certain: the sun will rise, birds will sing, and people will go back to work the morning after Election Day. And Lord willing – our routines will still be intact.

Let the countdown continue…

Good trading,

Tom Gentile