Simple Trades, Monster Profits

Module Four

Earnings Trade Examples

Jamie Dlugosch

The Earnings Player

Earnings Trade Examples

Now that we've completed our training modules, let's put it all together. We have our roadmap, our execution strategy, and our understanding of probabilities. We are armed with everything we need to trade earnings. So let's go big gain hunting with two real examples.

Starting with Delta Airlines, trading against the grain. Delta Airlines (DAL) Earnings Trade Example Identification We begin our analysis with identification. I'm going to assume we're doing our trading the week of January 18th. What is the current market narrative? Well the biggest story is the decline in oil prices leading us to the airline sector, and we find that Delta Airlines reports earnings on January 19th. Charts So let's look at Delta Airlines' chart. Here's a one-year chart for Delta and you can see lots of volatility over the last 12 months. But basically this stock has moved sideways.

This despite profit growth that has been very strong. We can also note that in each of the quarters that Delta announced earnings, shares jumped after the news was released. This bodes very well for the current quarter. Fundamentals

Well, we calculate the P/E gap by obtaining the current stock price, the current year estimate, and next year's estimate. For Delta the current stock price is $51.17. The current year estimate for Delta is $4.62. Next year's estimate is $6.37.

We have the three numbers we need to do our three calculations starting with the P/E ratio. To get the P/E ratio you take the current stock price divide it by the current year earnings estimate. So for Delta, that would be $51.17/$4.62, giving us a P/E ratio of 11.

DAL PE Ratio = 51.17 / 4.62 = 11 Next, we're going to calculate Delta's profit growth rate. The profit growth rate is next year's earnings estimate divided by the current year earning's estimate. So Delta's profit growth rate is $6.37/$4.62, or a profit growth rate of 38 percent.

DAL Profit growth rate = 6.37 / 4.62 = 38% Now that we have P/E ratio and profit growth rate for Delta, we can calculate the P/E gap by taking the P/E ratio minus the profit growth rate. So for Delta, that's 11 minus 38, or 27.

DAL PE Gap = 11-38 = -27

Delta Airlines (DAL) shares are Undervalued

Estimates Here we learn that Delta Airlines has exceeded estimates in four straight quarters.

Again, that's very good performance that we can expect to continue in the current quarter. We also learn that earnings per share trends are increasing.

For next year, the current estimate is for the company to make $6.37. 30 days ago, the expectation was for the company to make $5.75. That improvement again is very positive for the company’s forthcoming earnings. How do the estimates conform to the current narrative?

Well we have share price movements that are down and analysts' estimates that are rising. This is an inefficiency that we should exploit with call options. But we need confirmation. Confirmation So we'll go to the recent headlines. Here we see there have been negative headlines that have pressured Delta shares. We have low price competition threats, pilots demanding higher wages, poor weather, leading to selling that enhances our trading opportunity. The disconnect between the chart and the P/E gap suggests call options for earnings players. What's the summary for Delta, then? Well simply put, a sideways moving stock, and strong profit growth doesn't make sense. The company has a history of beating the number, and estimates from analysts are on the rise. This doesn't conform to the negative market narrative. Earnings Trade Recommendation: Buy Delta (DAL) at-the-money call options expiring January 22nd. We'll execute this trade in the last hour before expected earnings are released, and we'll close the trade one hour after the market opens the following day. There will be two outcomes for this trade. If earnings miss and the stock moves lower, our call options will lose 100 percent. But, if earnings beat and the stock rises, we have a potential gain of 600 percent on our call option with a 10 percent gain on the stock. The expected value of this two-outcome event is positive, thus we are going

to make the call option trade before earnings are released. GoPro Inc. (GPRO) Earnings Trade Example This is the ultimate in the news stock, in other words it's a momentum play. Identification First, we identify GoPro by asking what companies are reporting the week of January 25th. Are their any momentum stocks reporting in that week? We find on January 26th, indeed GoPro is releasing results. This busted IPO stock is a one trick pony product. Is it a fad, a tech stock, or media company? Shares are heavily shorted, there's lots of action in GoPro making it a prime candidate for an earnings trade. Charts So let's look at GoPro's chart.

Here we can go back to its IPO about a year and a half ago, and we see a lot of enthusiasm for the stock right after the IPO that doesn't last, and fades shortly after. We see a secondary rise in the stock when Wall Street tries to defend shares, but then disappointment with an earnings miss and the stock's falling below its IPO price right before the current earnings are to be released. Fundamentals What about the numbers and the valuation?

We need the P/E gap for that, so the three numbers we need are the current price for GoPro, that's $18.88. The current year earnings estimate of $1.17, and next year's estimate of $1.18. Once we have those three numbers, we can do our three calculations starting with the P/E ratio. That would be the current price divided by the current year earnings estimate. So for GoPro we have a current price of $18.88 divided by the current year earnings estimate of $1.17, that gives us a P/E ratio of 16 for GoPro.

GPRO PE Ratio = 18.88 / 1.17 = 16 Next, we calculate the profit growth rate. The profit growth rate is next year's earnings estimate divided by the current year earnings estimate. So GoPro's growth rate then, is $1.18/$1.17, or one percent.

GPRO Profit growth rate = 1.18 / 1.17 = 1% Next we calculate GoPro's P/E gap, we have the P/E ratio and the profit growth rate, and we subtract those two to get the P/E gap. So for GoPro, the P/E gap is 16 minus 1, or a positive 15.

GPRO PE Gap = 16 – 1 = 15 GoPro (GPRO) Shares are Overvalued Estimates What does the estimate page tell us? Here we learn that GoPro missed estimates last quarter. For a newly publicly traded stock, that is not good and does not bode well for next quarter.

We also see that estimates have been slashed. The company is expected to make $1.17 in 2015, 90 days ago that estimate was for $1.74.

But have the cuts gone far enough?

Confirmation Let's get our confirmation by looking at the headlines. This holiday season was GoPro a dud or the must have gift? The market has been slow to realize the fad nature of GoPro, and the company's facing increased competition from the likes of Apple, all these are negative headlines. In summary, we have a busted IPO stock that broke key price levels, and yet the stock at those low levels remains overvalued. Analysts' estimates are still too high, and the current negative headlines have actually resulted in the stock moving higher, again, that's an inefficiency that we can exploit with a put option trade. Earnings Trade Recommendation: Buy GoPro at-the-money put options expiring January 29th. We'll execute the trade in the last hour before earnings are released, and we close the trade one hour after the market opens. There are two outcomes to a GoPro trade, first if earnings beat expectations shares will jump and we'll lose up to 100 percent on our put option trade. But earnings miss, and shares fall, say by 15 percent, we will have a gain of more than 200 percent on our put option. Summary This gives us a positive expected value to this earnings trade, telling us we should make the trade before earnings are released. So let's wrap things up. I've given you the roadmap to trading earnings that makes the unpredictable predictable. When most traders run from earnings, we are going to attack earnings, and

exploit Wall Street. I've given you the steps to identify, analyze, and make a reasoned earnings trade without having a crystal ball. By following our roadmap to trading earnings you can make the unpredictable predictable, and therefore tradeable. Here are the steps in analyzing an earnings trade starting with identification. Our journey starts here with thousands of companies reporting results; we need a filter to key in on the few companies worthy of making a big gain trade. I use the earnings calendar, the current market narrative, and a focus on momentum stocks to pare down the list of companies that I'm going to analyze to find an earnings trade.

I start my analysis by reading the charts. Every chart tells a story, but are you seeing what's important to making an earnings trade? You have to ask the right questions so that we can identify inefficiencies that will lead to an earnings trade.

Next, we go to the fundamentals. Once we have the story of the chart, we move the numbers and here we learned a very simple and powerful technique called the P/E gap that will tell us if a stock is undervalued or overvalued at the time of earnings.

Then, we take a deep dive into the estimates. To complete our picture, how has the company performed the number? Are estimates changing? What happens in the estimates page will shed light on what's about to happen in the future.

Then we get confirmation. Once we have a general idea of the earnings report to come, we get confirmation by looking at the headlines and how the stock moves based on those headlines. All that's left to do then is to make your earnings trade, by following our simple earnings trading rules and guidelines for placing your trade and then sit back and collect your profits. Are you ready to trade earnings?

In this trading program, I've shown you the exact steps you need to identify, analyze, and make a reasoned earnings trade without having a crystal ball. With our roadmap, soon you'll be trading earnings like a pro instead of running away missing opportunity during earnings season. There really is nothing more rewarding than

the rush of reeling in that first big earnings trade. I'd like to thank all of you for taking the time and allowing me to introduce to you the exciting world of earnings trading. I truly look forward to many of you joining me on this journey each and every quarter. This is Jamie Dlugosch for The Earnings Player.

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