How many times have you called out a trade to an audience, and then watched it rip for a 10x gain in 24 hours?
Well, I just did it!
I know it sounds crazy, but this actually happened, and here’s the proof.
Does this happen all the time?
No, but it has happened before.
See, I know how to use option leverage on a particular type of trade that I want to share with you today.
It’s a cool little trick I learned over the years that creates one of my favorite risk/reward setups.
However, it only works in the right conditions, which I’m going to reveal to you right now.
You may not realize this, but the option chain tells you a lot about a stock’s earnings. Specifically, it lays out the market’s expectations for a movement from earnings.
I’m going to show you a quick trick to determining the market’s expectation for earnings.
Here’s a look at an option chain.
Hypothetically, let’s assume that Gilead had earnings coming up. The options market tries to price in the expected move based on earnings estimates.
You can figure out the expected move by looking at the straddle for the stock. If you don’t know what the straddle is, do the following:
- Take the put contract immediately at or below the current stock price
- Find the midpoint price between the bid and ask
- Do the same thing with the call option that is immediately at or above
- Add the two together
- Divide that number by the stock’s price to get the expected percentage move by that date
So, let’s assume that we’re looking at Gilead’s earnings. You would take the midpoint of the circled call option and circled put option and add them together.
That would be $1.79 + $1.58 = $3.37
This means the stock is expected to move $3.37/$77.43 = 4.35% due to earnings.
It’s worth mentioning that the expected move is tied to the expiration. You can use the weekly options to see what the expected move is by that Friday when they’re available.
Every so often, a company will surprise the market with positive (or negative) earnings that go way beyond expectations. In some cases, the market priced in a 5% move, but you wake up to the stock up 20%.
These types of moves are what create a trading opportunity.
To understand how this works, think of the other side of the trade. Someone sold Average Joe an out-of-the-money call they didn’t expect would pay off. Now, they’re staring at a loss as the stock goes higher.
So how do they stop the bleeding? They buy the stock. Guess what happens when enough folks do that? It creates a situation similar to a short-squeeze.
That’s what I’m playing for here. I want a stock that moves way beyond expectations and creates a similar situation.
Think about what that means. I can’t work with stocks that don’t trade options frequently. These won’t have enough sellers to create the squeeze.
Instead, I want to play with highly liquid stocks that trade a bunch of shares and options on a regular basis.
The morning setup
Now comes the tricky part. These trades do one of two things – break out or break down. They rarely just move sideways.
In order to get the right payoff, I need to play options. With options, my downside is limited to the money I invest. However, it gives me leverage for upside moves.
Back to the main example with TWLO, if I had traded the stock, I’d have needed 100x the capital to get the same return. However, if the stock dropped, I could have lost that same amount.
By using options, my upside is multiplied while my downside is limited. That means I don’t need the trade to work out all that often. As long as I get one big winner for every handful of losses, I’ll be doing just fine.
So, first thing in the morning, I look for options that balance the expiration and strike distance. Doing this gives me the most bang for my buck on a trade where I want to get a huge payout.
Typically, I’ll try to buy call options out-of-the-money with an expiration of the current week or the following week. The strike price I choose really depends on how much the stock moves as well as its average range.
Once I’ve gotten this far, the last piece is to try to get a fill. Generally, I’ll toss out some low-ball offers to see what sticks. Figuring out the right price is difficult.
The prior day’s options are a good place to start. Say a stock closed at $75 and opened today at $80. I might like the $80 options from the prior day when the stock was $75. So if it’s expected to open at $80, I might look at the $85 strike.
Note, option prices will typically contract the day after earnings as implied volatility shrinks.
Check it out for yourself
This is just one of the many trades LottoX has to offer. I created this service to help traders not see how I trade but learn to do it for themselves.