I love to trade options on stocks with a lot of momentum. What this means is that I want to trade those stocks, Exchange Traded Funds or Indexes, that are moving fast and far. The way I see it, if I am going to put my money in the market, I want to place it where it will work as hard as possible for me.
The first step to trading momentum is that you need to find a stock that has the capability to move fast and far. These stocks generally have a dollar or two-dollar average daily range during normal trading. Once the momentum picks up they can trend twenty to thirty points or so in a matter of a few months. Sometimes this momentum is sparked by news announcements such as earnings or a new drug approval, and sometimes it is just a stock that becomes heavily bought or sold by institutions. Whatever the case, once you learn to read technicals, you will be able to spot the building momentum in time to profit from the big move. This article will show you some ways to trade the post-earnings momentum.
Holding a directional trade over earnings can be risky, but after the release, the uncertainty of what direction the stock will move is gone. I like to trade after earnings because we often have an unusually large amount of trading activity that moves many stocks faster and further than they would normally go. It may be that earnings numbers were a big surprise, (they might be much stronger or weaker than expected) or it may be that traders were waiting to see what the quarter was like before they put more money into or took money out of the stock. It truly does not matter what the actual numbers are, mind you, because we are not trading the numbers, we are trading the reaction to the numbers. Checking a chart the evening after a company announces will show us if we have tradable momentum. If there is a great amount of buying pressure, I trade it up and if I see a lot of selling pressure, I trade it down.
For the purposes of this article, I would like to teach you how to make money on this strategy even if you do not have the time to watch the intraday chart. To do this, you need to recognize momentum as it develops on a daily chart. Many momentum plays begin as a breakout. A close above resistance should be viewed as a strong signal for the stock. After such a signal, I confirm with my indicators. I am trying to find any excuse to stay out of the trade. Any bearish indicator or bearish price pattern will prevent me from entering the trade. But, if all technicals confirm a bullish trade I enter the following day. One note of caution here: news may only have enough influence to move the stock for one day. Because of this, I prefer to enter my trades above the high (or the low if it dropped) of the day the news is announced.
Once our entry in this type of trade is triggered, you want to stay in as long as there is continued buying pressure. Often the buying pressure and momentum will move a stock for only three to five days. These momentum plays can be traded as one trade that you will stay in as long as you have enough time in your option or as something you can position in and out of to pull profits out along the trend.
The entry on this type of trade can feel risky because of the gap. The danger with gaps is that all the trade may be taken in the gap and there may not be enough buying or selling pressure to move the stock further. For example, when the Chicago Mercantile Exchange (CME) announced they were buying CBOT Holdings (BOT), the CME gapped to an all-time high. The opening price was over ten points above the long day candle you see earlier that month.
After the open, no one was willing to pay a higher price for the CME and the stock dropped like a rock. When a stock gaps beyond a price at which it was comfortable trading, you can rest assured that much of that play was taken in the gap and the safest way to trade it may be to trade the retracement. One thing you can do to make trading a gap on news safer is to avoid the trade unless the gap puts the stock near its recent trading range. In the case of CME, the stock was so far above where traders were comfortable buying it that people took profits out very quickly.
A news announcement such as earnings can present wonderful trades. The momentum associated with the news may create a lot of buzz around the stock and draw more buyers into the stock, or motivate people to sell the stock in droves. Either way, we can trade it. Check the technicals first to make sure everything is bullish before buying calls or that everything is bearish before buying puts. And remember that as long as the stock gaps to a price that it has traded recently, there may be plenty of room left for the stock to move. Enter the trade and manage your risk by placing your stop. This is one easy way to build your account up trading momentum during earnings season.