Always trust your instincts! This is one of the most important lessons that you must learn as a trader. I trusted my instincts earlier this week, when a parade of earnings reports kept me from placing pre-earnings trades in some of the stocks I’ve been wanting to buy. I’ve taken a few hits on earnings lately, which, to be honest, had me shriveling up ahead of these events. Taking losses is a regular part of trading. Don’t let anyone tell you otherwise. As long as you plan ahead of time by entering trades with good risk/reward and predetermined stop levels, taking small losses becomes an important part of developing good trading instincts.

Today I am going to show you how my instincts kept me from taking a huge earnings-induced loss earlier this week, and how I may now be set up to buy a stock I’ve been wanting to buy at a steep discount. 

Market participants set expectations ahead of earnings

Traders and investors create expectations leading up to earnings announcements by speculating on where they believe a stock should be valued. This gets reflected in a stock’s price, as it either rallies or falls leading up to the earnings report. When the earnings report shows results that fall short of the expectations that have been built up by the market, the shares often fall sharply as a result. Conversely, shares often rally if earnings beat expectations. But it’s not always so straightforward. That’s because it’s not uncommon for shares to fall even if the company’s earnings beat expectations, or rally when they don’t.

The fact of the matter is there is so much going on in corporate earnings reports,  like debt levels, cash burn rate, margin rates, etc., that it’s hard to satisfy the expectations of all market participants. For Upstart Holdings Inc. (UPST), it was the company’s outlook that underwhelmed investors’ highly inflated expectations for the future during this past Tuesday’s earnings announcement. As a result, the stock collapsed 23% overnight on Tuesday, in the worst daily drop since March.

Now that the price has been corrected, I feel there is a buying opportunity coming up soon in this name. With implied volatility kicking up here, I want to look to sell into this by using a credit put spread instead of buying calls.

Here’s what I like about the current price levels.

According to Yahoo Finance, Upstart Holdings, Inc. operates a cloud-based artificial intelligence (AI) lending platform. The company’s platform aggregates consumer demand for loans and connects it to its network of the company’s AI-enabled bank partners. Its platform connects consumers, banks, and institutional investors through a shared AI lending platform. Upstart Holdings, Inc. was incorporated in 2012 and is headquartered in San Mateo, California.

As Figure 1 shows, this past Tuesday’s overnight gap lower found support at a confluence support levels.

Figure 1

I often reinforce how important it is to find buying opportunities that are backed by multiple levels of support. With this week’s earnings-induced collapse finding buyers at a combination of the Anchored VWAP, Fibonacci retracement, 100-day moving average, bottom of a rising price channel, and internal trendline (dashed green line), support doesn’t get much stronger than this. Because of this and the RSI momentum indicator’s recent bounce from very oversold levels, the share price should not move much lower from this level in the short term.

Identifying big support levels like this is critical to establishing good risk/reward for your bullish trade. That’s because, theoretically, you would build a long position as close to this support as possible, which means any unexpected price weakness below this support would cause you to stop out of the trade with not a lot of downside risk.

What type of bullish options trade am I considering?

While I don’t have any reason to believe that the share price should rise aggressively from current levels, I do think that this support will hold. When I consider the rising volatility that we are now seeing, that means it’s a favorable opportunity to take advantage of the passage of time as shares start to bottom out above this support area.

I like to do this by utilizing a bullish put vertical credit spread.

You see, as the stock has been falling recently, the volatility has been rising, causing the amount of time premium built into put options to increase significantly. I want to take advantage of this situation by selling an option spread that will allow me to collect this premium as the stock starts to base above support. The beauty of these bullish credit spreads is that price doesn’t need to do anything except remain above a certain level as expiration draws near, and that level will be somewhere close to the support level I’ve identified on the chart.

A put credit spread, often called a bull put spread, simply involves selling a put option with a given strike price and simultaneously buying another put option at a lower strike price. Both options have the same expiration date. The purchase of the lower strike price call protects (covers) the short position and puts a limit on the amount of money that can be lost on the trade.

In the case of UPST, I would look to anchor a bull put spread right near the massive $255 support level by selling a put with a strike of either $255 and buying a put just below that, around $250 to $245, for protection. Again, if the price were to start to fall below this spread, we’d know something is very wrong with the stock and we’d be able to get out of the trade with a limited loss.