Trade Earnings with Minimal Risk

04/14/2011 3:00 pm EST

Focus: STOCKS

Scott Redler

Chief Strategic Officer, T3 Trading Group

Trading popular stocks after earnings reports provides lower risk while still allowing good profit potential, explains Scott Redler of T3Live.com, citing recent trade examples.

Earnings season can be a tricky time for traders. There’s a lot of volatility, a lot of things happening in stocks. They move quite a bit. 

Our guest today is Scott Redler, who’s going to talk about how we can trade during earnings season and minimize our risk. So Scott, first of all, talk about how you do this during such a volatile time.

There’s definitely an art to trading in earnings season, and as a risk-averse trader, it’s hard to trade the momentum stocks without the volatility and the risk. 

What we did is we put together a plan for trading the stocks after earnings. The stocks that come out, beat (earnings estimates), guide up, have a big move within the first day, and then hold that move. Because that second move becomes that much more explosive. 

So what you want to do is you want to wait for a big gap up, and then you want to wait for some sideways consolidation, and then it creates a pivot point where active traders that don’t want to take the overnight risk during earnings can still be rewarded by a momentum move. 

So some of the key stocks that we trade are Baidu (BIDU) and Netflix (NFLX), among others. I want to use them as an example.

Baidu, months ago, the CEO said that 2011 growth may slow. So people weren’t sure if Baidu’s run was over or if it could continue. So this earnings was key in answering those questions. But it was a coin toss going into earnings: What are you going to do, take it long or take it short?

Some traders, if someone had to trade it, I said just take in-the-money options. So, at least you know your risk is premium paid. I said for the patient, prudent investor, take it after the earnings. Watch four or five days.

So Baidu had great earnings and gapped up, as you can see here.

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It went above the 52-week high of $115. It hung out there for four or five days, developed a wedge—a very tight pattern—so you had shorts trapped from the gap up, you had people who didn’t take the risk into being long say I want in. 

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So once it triggered above $120, that was your buy price. Your stop was in the middle of the base, and then traders had a momentum move from about $120 to over $130 in four sessions. They got paid by being patient, and with a very low risk.

NEXT: See Post-Earnings Trade in Netflix (NFLX)

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Netflix is similar. Netflix is a very popular stock to trade, so you’ve got another example with that stock as well.

Yeah, Netflix is such a heavily-shorted stock. People have been betting against this for two years. This has been an unbelievable trader for us. With 20% of the float short and only like 55 million shares traded, it moves.

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So, with Netflix, also, you had to see what the report would be, and there would be a lot of volatility afterwards.  So instead of making a guess into the report, you can wait until after. 

So, Netflix came out. There was a great report. They got it up. Their subs were big, nice growth. More importantly, it gapped above the prior high, which was right around the $205, the $208, and just like Baidu, it held there.

It held there for about five to eight sessions, making a wedge. A wedge is a pattern of indecision of which is the next direction. 

So, we put in a plan to buy Netflix once it traded above $216 to $217 because that was the prior high. That’s when there would be another short squeeze. That’s when the pattern resolved to the upside, and without taking the risk of buying into earnings, you could have bought above that $216 or even $228, more like $228, and the stock went to $245 in a matter of three to four sessions.

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As you can see, another explosive move with very calculated risk. 

NEXT: See How to Trade an Overreaction to Disappointing Earnings

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Now, does this strategy work best with really highly-liquid stocks that are in the news a lot, the Apples of the work, Netflix, Baidu, that sort of thing?

It works best with stocks that move and during earnings season. There are some traders in my firm that could trade them once they’re reported after hours, and I don’t recommend that to anyone. It’s like the Wild West unless you’ve been doing it for a while.

There’s an art. There’s an art to any of these type of situations, but I do think the most risk averse is let a stock come out with great earnings, great guidance, open up in a gap, and then hold that gap for a series of…it could be three days, it could be ten days. 

If it doesn’t close that gap, that shows power. That shows shorts are trapped. Longs that wanted a dip can’t get a dip, so they have to pay up once it crosses over the pivot level for a future move.

Those seem to work out very well with very low risk. 

Do some stocks tend to overreact, and you can play actually the overreaction, the move back down if it really gaps up, or if it goes down too far, it’s an overreaction and you can play that up?

You can because, the cloud computing area, F5 Networks (FFIV), one of my go-to stocks of the year, that actually came out with numbers and The Street thought they weren’t enough. 

So it gapped down big. We didn’t take it into earnings. It’s the same way we didn’t take Baidu and we didn’t take Netflix, and it was a little bit of an overreaction.

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So, it went down to, I remember, $110, and then built a new lower base. This time it was a different trade. Once it traded above $114 or $115, which you’ll be able to see on the chart, you’ll see it traded into the gap of overemotion. People sold it off too quick. 

So you could have bought at $115 with a stop at the low end of that range, and then the stock within days was above $120 and went as high as $128 to fill a big portion of that gap.

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That was the opposite end where the gap didn’t hold it, so that the sell side wasn’t in control.

The same way if Netflix and Baidu broke into the gap and it couldn’t hold, the buy pressure would have eased.

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