Earnings Season May Yield Big Profits

07/09/2007 12:00 am EST

Focus:

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, chairman and CEO of Schaeffer's Investment Research, says low expectations may give stocks a boost when the companies report earnings-and options traders could do even better.

Second-quarter earnings reporting season [begins today], and despite the fact that many companies blew away investors' expectations last quarter, consensus expectations for earnings are still very low-hovering around 4% growth.

Why is this good news? Because low expectations often lead to big earnings surprises. And big earnings surprises can translate into huge trading profits! It certainly did last earnings season.

In many ways, the sentiment picture for the upcoming earnings season looks very similar to last earnings season. It's the kind of earnings season that's an options trader's dream, because these big stock moves can translate into huge gains for options traders, [for] three major reasons:

1. Double-digit earnings growth is over, but triple-digit profits are just beginning!

As we all know, the market's reaction to earnings season announcements is all about earnings expectations, not earnings reality.
Last earnings season, analysts expected a 3.2% earnings gain when the season began in early April. But companies did better. A lot better.

According to BusinessWeek, a whopping 66% of Standard & Poor's 500 companies beat estimates. And many of them beat estimates by a mile.

Continued low analyst expectations-even in the face of last quarter's strong earnings-means the chances for an earnings season full of positive surprises is high.

2. All signs point to a continuing bull run.

With investor expectations incredibly low, I believe we could see some huge jumps to the upside this earnings season. And that would lead to some great profit opportunities on call options, with gains of 100% possible on 10% moves in the underlying stock.

Caution and skepticism prevail across Wall Street and Main Street, as investors have yet to fully buy into the market's upward momentum. Investors have greeted the big milestones hit in recent months-like the Dow Jones Industrial Average and the Standard & Poor's 500's rallies to all-time highs-with some pretty big yawns.

Meanwhile, short-selling activity continues to build momentum, even as the market [approaches] new all-time highs. I believe these huge short positions have to be unwound at some point in the future and thus represent future buying power.

Finally, market liquidity is at an all-time high, which will likely help drive the market higher.

Trading options this earnings season is a good way to make some fast returns... without tying up a lot of cash.

3. Despite recent volatility, options prices are still about as low as they go.

Right now, despite a slight increase in recent weeks, the expected volatility priced into the options market is still modest compared to its highs historically, and options prices on individual equities are especially modest.

If we continue to see increased volatility in the market-and we almost always do around earnings season-these option premiums could jump dramatically. But right now, you can get in the game at bargain basement prices.

Click here to see a recent Webcast of Bernie Schaeffer on MoneyShow.com...

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