Why Trade Stocks?

Why Trade Stocks? 

That was the question just raised by Zero Hedge partner The Market Ear: 

Just trade options given the latest volatility crash. Options are cheap and offer attractive ways to play directional trades.

We took The Market Ear's advice yesterday, using options to place four directional trades on stocks releasing earnings after the close yesterday or before the open today (Trade Alert: Earnings, 11/20/2023): 

• Dick’s Sporting Goods (DKS 5.28%↑) (bullish)
• BellRing Brands (BRBR 4.31%↑) (bullish)
• Burlington Stores (BURL 20.82%↑) (bullish) 
• Kohl’s (KSS -9.56%↓) (bearish)

Unfortunately, we didn't get a fill on DKS, but we got fills on the other three yesterday, and exited them today for gains of 63% (BRBR), 109% (BURL), and 107% (KSS), respectively. Here's a recap of the process we used, if you want to try this at home. 

Our Ten Factors For Evaluating Earnings Trades

We use these ten factors for evaluating earnings trades: 

• LikeFolio’s earnings score based on social data. The higher the number, the more bullish, the lower (more negative) the number, the more bearish.

• Portfolio Armor’s gauge of options market sentiment.

• Chartmill’s Setup rating. On a scale of 0-10, this is a measure of technical consolidation. For bullish trades, we want a high setup rating; for bearish trades, a lower one.

• Chartmill’s Valuation rating. On a scale of 0-10, this is a measure of fundamental valuation incorporating common rations like P/E, PEG, EBITDA/Enterprise Value, etc. For bullish trades, the higher the better the Valuation rating the better; for bearish trades, the reverse.

• Zacks Earnings ESP (Expected Surprise Prediction). This is a ratio of the most accurate analyst’s earnings estimate versus the consensus estimate.

• Zacks Ranking. A number from 1 to 5 with 1 representing their 5% most bullish stocks, 2 representing their next 20%, 3 the middle 50%, and so on.

• The Piotroski F-Score. A measure of financial strength on a scale from 0-9, with 9 being best.

• Recent insider transactions.

• RSI (Relative Strength Index). A technical measure of whether a stock is overbought or oversold. We’re looking for RSI levels below 70 for bullish trades and above 30 for bearish ones.

• Short Interest.

Quantifying Bullishness And Bearishness

To compare apples to apples, we assign simple numeric rankings to each factor. For most of them:

• Very Bullish = 2

• Bullish =1

• Neutral = 0

• Bearish = -1

• Very Bearish = -2

Social Data

For social data earnings scores, Likefolio considers +20 and higher to be bullish, and anything -20 or lower (more negative) to be bearish. For our purposes, I considered anything between +20 and +39 to be bullish (1), and anything from +40 to +59 to be very bullish (2). A rare score of 60 or higher I gave a 3 to.

Options Market Sentiment

For options market sentiment, we’re looking at the cost of hedging a stock against a >9% decline over our default time to expiration (roughly six months) with an optimal collar capped at 1%.

Screen captures via Portfolio Armor.

We run a daily ranking of securities with positive price momentum sorted by the cost of hedging them as above; currently the hedging cost of the top ten names on that ranking goes from -7% to -5.8% of position value. Since BABA above has a hedging cost of -7.23%, we give it our highest bullish ranking for options sentiment, a 3. Stocks with hedging costs between -5.8% and -7% would get a 2; between -3% and -5.7% a 1; between 0% and -2.9% a 0 (neutral); between 0% and 8.9% a -1, and anything above 9% a -2, for very bearish.

Set-up and Valuation Ratings

These two Chartmill ratings are on a scale of 0-10. We give scores of 0-2 a -2 (very bearish), scores from 3-4 a -1, 5 a 0 (neutral), 6-7 a +1, and 8-10 a +2.

Piotroski F-Score

Scores from 0-2 get a -2, scores from 3-4 get a -1, 5 gets a 0, 6-7 gets a +1, and 8-9 gets a +2.

Zacks Earnings ESP

A single digit negative score, say -3.21%, gets a -1; a double digit negative score gets a -2, a 0% score gets a 0, and a single digit positive score gets a +1, and a double digit positive score gets a +2. Rare, extreme scores in either direction, get -3 or +3.

Zacks Ranking

For this one, the raw number (1 through 5) is the same number we use.

Recent Insider Transactions

Most of these get a 0, for neutral, as large companies in particular often have frequent insider selling, and if that’s part of regularly scheduled sales, it’s not clearly bearish. Notable net insider buying or selling shortly before earnings gets a +1 or a -1, respectively, with higher numbers for rare, extreme situations (like a stock where every open market insider transaction over the last year was a buy).

RSI

Anything between 30 and 70 gets a 0, for neutral. Between 29 and 25 (oversold) gets a 1, and under 25 gets a 2. We haven’t seen any over 70, but those would get a -1, and maybe a -2 if over 80 (over bought).

Short Interest

Short interest of less than 10% gets a 0, for neutral; between 10% and 19% gets a 1; between 20% and 29% a 2, and above 30% a 3.

Tracking Performance of These Factors

For each stock we evaluate each week (not just the ones we place trades on), we enter the data above in a spreadsheet, and at the end of the week, we record each stock’s 5-day return.

Then we compare the average 5-day performance of all the stocks with the average 5-day performance of the ones that had social data scores of +2, +1, etc.

Seeing What Works And What Doesn't And Adjusting Accordingly 

Tracking the performance of everything each week lets us see what works and what doesn't work, and adjust accordingly. That includes taking into account some counterintuitive results. 

For example, Piotroski F-Scores above 8 are considered excellent, but so far in our tracking, stocks with scores of 8 and above actually underperform, so, all else equal, we currently count an F-Score that high as a negative when evaluating potential trades. 

Three More Trades For Thanksgiving Week

We just placed three more directional trades on stocks releasing earnings today or tomorrow, including the biggie, Nvidia (NVDA -1.96%↓). If you're a subscriber to our trading Substack, check your inbox for our trade alert; if not, feel free to subscribe below. 

If You Want To Stay In Touch

You can scan for optimal hedges for individual securities, find our current top ten names, and create hedged portfolios on our website. You can also follow Portfolio Armor on Twitter here, or become a free subscriber to our trading Substack using the link below (we're using that for our occasional emails now).