Financial Literacy

How Options Can Be Used to Predict Profits in the Stock Market

The stock market presents traders with opportunities every day.

Some are more obvious than others, as press releases can put the spotlight on certain stocks and impact shares before or after the market is open.

Of course, news is also released during the day. But unless you are glued to a screen and have a quick-trigger finger, you will most likely miss out on any significant moves the news creates.

Some market participants can move in milliseconds… so even if you’re able to act in seconds, you’ll be far behind.

We live in an age of lightning-fast connections and machine technology that trades using complex algorithms. Emotion and judgment do not cloud the actions of a supercomputer.

But one instance offers you as close to a level playing field as you can get. This occurs when a company reports its earnings.

Companies release earnings either after the markets close or before they open. Sure, you can play the stock in the aftermarket or the premarket, but you can’t play options then.

The options market tells you ahead of time what the investing community – including those multimillion-dollar computers and highly paid algorithmic formula creators – thinks the numbers will be and how a stock will react when the market opens.

Is it perfect? No.

But it’s as close as you’re ever going to get to a level playing field.

Here’s the catch…

First, the reaction to earnings reports is not always accurately indicated by the options market.

Second, you may know the size of the reaction to the earnings report ahead of time, but you are not going to know the direction.

So, today, let’s focus first on calculating the reaction.

The reaction is called implied volatility. It measures the implied percentage move in the stock after the release of earnings. That implied move can be immediate, or it can build over a period of hours or even days.

Luckily for you, there is a quick formula to calculate this…

Take a look at the stock price and choose the options that have the closest expiration and the closest strike price to where the stock is trading. Do that for both put and call options.

Then add up the price of the put and the call, and divide that number into the current share price. That gives you a percentage approximating the move expected by the market.

As an example, take stock “X”…

Assume the shares for stock X are trading at $20. You look up the options chain and see that there are weekly options. The $20 call option is trading for $1.20, and the $20 put options are trading for $1.00. That is $2.20 in total. Divide $2.20 by $20, and you get 11%.

That is the expected move for the shares. It’s that simple.

Now, that 11% doesn’t give you the direction of the shares. It just gives you the expected move.

But in tomorrow’s Trade of the Day I’ll show you how to play that expected move!

Action Plan: In The War Room, we use these formulas, along with research and other proprietary indicators, to give members the best possible chance at making blowout profits when earnings are being released.

Our profits have been phenomenal at times. And there are a slew of releases coming up soon. Find out how you can participate and trade with me and other professional traders in real time in The War Room!


About

With more than 20 years of experience, Karim has mastered the subtle art of options trading. What we admire about him is his ability to score huge gains while minimizing the massive amount of risk that often comes with options. Beyond his expertise in options trading, he is also the author of the best-selling book Where in the World Should I Invest? He publishes weekly about smart speculation in his latest free e-letter, Trade of the Day.

Articles by
Related Articles