Trade the News with Less Risk

10/11/2011 4:00 pm EST

Focus: STRATEGIES

S. Wade Hansen

Founder and Managing Partner, Learning Markets

Trading on news events, earnings reports, and economic announcements can be very profitable, but also very risky. Wade Hansen explains two ways to make money on news events that impact the markets using options.

How should you trade the news? Today we’re talking about that topic with Wade Hansen. Wade, how do you recommend traders respond to planned economic reports or corporate earnings news that’s on the horizon?

I think the first thing you need to do is decide how aggressive you like to be as a trader because there are a few different ways that you can trade earnings announcements, economic announcements, and such, but each one carries a different level of risk and reward—or potential reward—for those trades.

If you’re a little more conservative, you might want to try and front run those announcements. If you start to hear some chatter in the marketplace about where an economic announcement may go, if you can get in a week or maybe two weeks before, you can see a slight change in price and get out right before the announcement comes so you’re not holding that risk over the actual announcement.

If you want to be a little more aggressive, then naturally, you want to take a position before the announcement and hold all the way through. Now there’s obviously going to be some increased volatility with that type of a strategy, but with the increased risk comes the increased potential reward.

So with either of those strategies, the key thing to remember is your money management in both. You never want to overextend yourself on any one position.

Now this reminds me of the old adage “Buy the rumor and sell the news.” Does that come into play at all?

Right, it does. You can really take advantage of this with options in earnings announcements.

Often times, when you have a lead-up to an earnings announcement, what you’ll see in the options market is that implied volatility levels start to pick up.

Now with a long call or a long put, if implied volatility levels start to pick up, that’s going to inflate the premium of that option. So you can actually see an option increase in value not because the underlying stock has moved anywhere, but because the implied volatility has increased, and that produces a profit on your option premium.

Then, if you exit right before the announcement comes out, that’s typically when implied volatility is at its height. So you can take advantage of the implied volatility change without holding over and taking the extra risk of actually holding through the announcement.

Now frequently people will make a trade ahead of an earnings report they expect to be good. The company then misses views and the stocks falls. What should a person do in that case if they’re still holding through that report?

Well if they’re still holding, most of the time a company will announce either after the market closes or before the market opens the next day. So you’re going to have a gap one direction or the other if the company misses estimates.

Now, if you see the stock drop, you have to look around at what is happening in the rest of the market and what the initial reaction to that drop is.

If you see a stock drop, but the rest of Wall Street is going gangbusters to the upside, the chances of your stock recovering part of that gap are actually pretty good.

But if you see your stock drop and everybody is running for the exits on Wall Street across the board, you’re going to want to try to exit sooner rather than later.

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