The shadows can be found deep in the forest or they can be there in front of your nose. The trick is in knowing how to act when the shadow is found.
My shadow of late is quite the doozy. For several weeks now, companies that report earnings results have been a mixed bag. There are winners and losers. The shadow is in how the market reacts to the news.
When the news is good, stocks are seeing gains in the 2%-4% range on average. When the news is poor, watch out below. Losses for a disappointing report can range from 10%-20% on the downside.
It is a huge money-making opportunity and the dynamic is solidly in play for when earnings season begins in earnest next week. Last week’s big winner for those shorting stocks set to report earnings was Finish Line (FINL).
The company delivered on the bottom line, but warned investors about a weaker-than-expected first quarter. That news resulted in shares losing more than 16% on Friday after the report was released.
I targeted Finish Line in my weekly article here, but really honed in on the stock late in the week. With the overall market showing surprising strength after what has been an impressive and exhaustive rally I knew that Finish Line had some powerful downside.
The metrics that I use to help identify stocks to trade during earnings season showed signs of a potential collapse. Specifically, expected earnings growth from the current fiscal year to the next was set to hit single digits. At the same time, shares of Finish Line traded for a double-digit multiple of earnings.
Shorting or trading options
One of the issues some of you may have with this particular shadow is that in order to profit from the arbitrage one must be short the market. Shorting stocks is not for everyone and it is not entirely easy to do. A possible solution would be to trade options instead.
With Finish Line, I made the suggestion that traders buy the $25 strike with April expiration Put contract in order to exploit this trading opportunity. On late Thursday afternoon before the report was released, those contracts traded for $1.20 (the ask or price you would pay to enter the trade).
Buying 5 contracts put the total exposure to the trader at $600. Shares of Finish Line traded right at $25 as of Thursdays close. On Friday after the report and shares down solidly the Put contract traded for more than $3 (the bid or the price you would fetch for selling the contract).
Total profit on this trade then was nearly 200% in less than 24 hours.
Here are five companies reporting results this week to potential trade in a similar fashion: