Trading Options with an Edge
Select Page

OptionsHawk Education

Earnings Drift Trade Setups

by | May 22, 2022 | Strategy

What is Earnings Drift?

Every quarter when companies report their earnings the market reacts to it and sometimes the stock will move greater than the implied move in the options market was pricing. This is essentially the setup for an earnings drift trade. The earnings drift is an occurrence that has been followed for a while and is when a company reports much better than expected numbers and the stock rallies sharply higher for days or even weeks after in a “drift” like fashion. Depending on the broad market and where the stock is on its price chart, the stock may simply drift sideways to higher or continue to breakout to new highs strongly. This can work on the down side too, especially in bear markets. If a company reports worse than expected earnings the market will punish it severely and the stock may bleed lower for several weeks before it shows any life.

How much a stock moves on earnings can vary based on their beta and overall volatility so a 10% move for one stock might seem high but if the options market expected a 10% move based on the implied volatility levels then it’s not outside of expectations. Understanding what the options market is expecting is step one to this trade idea so reading up on Expected Moves which I have written about before is a good primer. Stocks are all about expectations and the options will always give a good clue into what the market is expecting. It’s those outlier moves that catch the market makers off guard and move 2 times the expected move or greater that create opportunity. That opportunity is the earnings drift trade setup.

Sometimes this trade opportunity can be a small continuation move for a few days or sometimes it can produce massive gains if there is added fuel such as a high short float in the stock that forces shorts to cover into strength. Of course this is much more likely in a bull market like that of 2020 and 2021 when new highs were a common theme month after month. The overall market environment should always be a guide post to understanding what the potential of this trade opportunity is. If you don’t like to enter a trade before earnings due to the unpredictable nature of the outcome, then the post earnings drift trade is a great way to still participate in a potential move. The nice part is these kinds of moves happen over and over, and when they do, it is rarely a one day move. 

 

Earnings Drift Trade Setup Parameters (reverse for short trades)

  • Monitor earnings reports from liquid stocks in play and compare the stocks implied move to what actually happens the day it opens for trading after the reaction. 
  • If a stock has a 5% expected move and it moves higher by 10% or more, that qualifies as 2 times the expected move and meets the criteria for an earnings drift trade. We are only interested in stocks that open at least 2x the implied move. This is because once that level is exceeded it forces dealers to hedge into the move which creates a domino effect in that direction. 
  • You can trade this as a day trade for momentum or a swing trade for multiple days or weeks. 
  • When the stock opens the day after its report, I like to watch the first 5 and 15 minute candles form. If the stock is gapping higher after its report, then a break above the first 5 or 15 minute candle is a buy signal to jump in. 
  • You can play this either using stock, buying calls or what I do sometimes is sell put spreads in the next weekly expiration, expecting prices to at least stay above the opening print. 
  • It’s a continuation momentum trade so if entering into a swing trade then ideally it starts to work that day and you don’t take heat, but a general rule I have is the trade should work within 3 days. If it fades below where it opened  and cant recover in 3 days that’s usually a sign it was a dud and you should move on to the next one.
  • Profit target should be open and can either look for a previous high or wait for the trend to change since it’s a momentum based trade. I usually like to wait for the stock to break under the previous day’s low to signal an exit. The examples below should illustrate this better.
  • Risk per trade really should be limited to 1-2% of your account per trade. If it works it’s often good for 2-3x the amount risked so it offers a great risk/reward usually.

 

Earnings Drift Trade Examples

 

Example 1: Netflix (NFLX) 

On 4/20/21, NFLX gapped down much more than expected after reporting poor earnings. The stock was pricing about a 10.5% implied move based on the options market. It opened the next morning down 30%. About 3 times the expected move to the downside. That might make some traders think it’s a time to buy the dip but it’s rarely the case when these Earnings Drift trades occur. Especially if the move is in the direction of the overall trend on the daily chart and broad market. These types of events tend to continue to “drift” in the direction they came from due to the amount of trapped market makers and investors. Dealers or market makers need to sell short stock into weakness to balance out their delta exposure from likely short naked puts. The reason is often not the important thing but I know some people like to have a reason. 

In the daily chart you can see NFLX continues lower for several days in a row after the initial gap down candle. The stock was so weak it could not even get above the previous days high until 6 days later where point 2 is labeled. On this day a reversal candle formed which could have been an exit trigger from the short trade setup. The close on this day was 199 after making a low near 186. From an initial entry near 235 after the first 15 minute candle was breached to the downside, that is a solid winning earnings drift trade. The stock went on to make even lower lows as the overall market was quite weak during this time as well. These trades seem like you will always be getting in late after the big move has been made but the thing is when the floodgates open after a monster move it tends to have a lot more momentum that needs to be released fully.

 

 

Example 2: Roblox (RBLX)

At the end of 2021, RBLX was one of the darling momentum stocks of the bull market and on 11/8 it reported great earnings that resulted in the stock exploding higher well beyond the expected move. The options were implying about a 10.5% expected move on earnings. The stock gapped higher the next day and opened up about 30% before finishing the day higher by 42%. This example is an interesting one and perhaps a bit trickier because a trader could have played it multiple ways and times. The first chart shows the daily chart as the stock had some volatility the few days after reporting. Initially a strong green candle was sold the next day but the red day did not close below the low of the gap higher candle. The 3rd candle labeled as point 1 shows an inside day candle that sets up an opportunity to trade a breakout higher above the white horizontal line. Once RBLX cleared that high of the inside day candle it didn’t look back. Closing higher for 6 straight days into all time new highs before reversing from 141 on 11/22 and forming a bearish selling candle. The move back under 128.50 would have been the exit signal if a trader was still long the stock from the original entry near 100. 

 

 

The second chart below shows RBLX during that same time post earnings but instead this time zoomed in on a 15 minute chart showing an example of how this play could have been day traded for a quicker move the day of earnings. Similar to the daily chart, RBLX opened volatile and tried to form a range the first hour of the day. Eventually the 3rd 15 minute candle formed an inside candle and price broke out above that spot where the arrow is shown. The stock quickly made a new high of the day and proceeded to grind higher the rest of the trading session and close at the highs near 110. This could have been traded multiple ways depending on the timeframe you prefer but the point of this earnings drift setup is to look for price action to continue in the direction it came from because the expected move being exceeded means many traders are the wrong side of the move and they will likely push it further since they need to in order to exit.

 

 

Keys to Consider

The earnings drift trade can be used to the upside in bullish moves or to the downside for bearish moves. It helps to be in the path of the dominant long term trend and overall market behaving in the same direction tends to have the best outcomes. The broad market will always be the focus before taking a momentum trade so it’s important to understand the environment we are in whether it’s a bull or bear market bias since this tends to power the momentum that occurs beyond the expected move of what the market was anticipating into an earnings report.

Every month there are large gap style moves in stocks that report earnings or just unexpected news as well. Another example of this was Tesla (TSLA) during the late October 2021 parabolic runup after the news it was partnering with Hertz. The stock gapped higher into all time highs and continued to rise for weeks. I have noticed that where a stock is in relation to its 52 week high or low or even all time highs makes a difference in the potential power of the earnings drift trade outcome. You want to target names that are making outsized moves into space or lack or resistance on the upside. 

The main filter I try to focus on is the 2x implied move. Can it be played with a 1.5x expected move? Probably but keeping it simple and knowing when a stock has exceeded 2 times its options expected move makes it more clear that there will likely be continuation into that direction and the setup is meeting specific parameters that can filter out the noise of other earnings moves. Then riding that momentum for all its worth. 

 

Takeaways:

  • The earnings drift phenomenon is when a company reports much better than expected numbers and the stock rallies sharply higher for days or even weeks after in a “drift” like fashion.
  • This can be applied to the downside during a bear market or overall downtrend where a stock exceeds an implied move lower.
  • Targeting a previous high as a way to take profits in half the position and then trailing a stop level below the prior day’s lows is an effective way to stay in the momentum trade.
  • The key criteria is a liquid stock that has gapped at least 2 times its expected move in the options market. This ensures that its an outlier move that tends to continue its drift in that direction.