June 3, 2013 - Making a profit after news has been released
Each week on our site, we feature four analyst insight articles that take an in-depth look at recent events that are moving the market. We look at current events that are affecting Wall Street, examine trends that could direct the market and try to pinpoint opportunities to profit.
For traders interested in daily trading opportunities, we offer the InvestorsKeyhole service. This service is run by the same options experts who write the weekly articles, and each day we offer four trade ideas that have a target return of 4% or greater.
There are several ways we determine which securities we will feature in our daily InvestorsKeyhole service. One way we select securities is by looking over the big new stories of the day, such as a positive earnings report, a broker upgrade or even positive comments from the company’s CEO.
When big news comes out overnight, the result is often a gap open. When the news is positive, we see securities open higher at the start of the trading day than they closed at the end of the previous day. The better the news, the higher gap. Unfortunately, by the time the stock opens higher it is too late for investors to take advantage of the good news.
However, there is a way to still profit from the good news even after the stock has made it gains. The reason why there is still a potential profit to be made is that once the good news sends the stock higher, it is unlikely that the stock will fall in the next couple of months.
Because we expect stability in the upcoming months, we can set up bull-put credit spread on the stock. To understand why a bull-put credit spread on these recent movers is a safe bet, you need to first understand how a bull-put credit spread works.
Setting up a bull-put credit spread involves selling a put on an underlying security while at the same time buying a put at a lower price for the same security and the same expiration month. When we set up these trades, we do so with both puts being out of the money. As a result, these trades are profitable as long as the underlying security does not fall below the strike price of the sold puts. Therefore, the security does not have to rise in order for us to profit, and in fact it can actually trade lower and still allow us to realize our target return.
We will often use this strategy on a broad sector of the economy by setting up a trade on an ETF, or exchange-traded fund. ETFs add an extra layer of security to our trades because they are widely diversified. Their diversity keeps them from making big moves to the upside, but more importantly for our needs, it prevents them from making big moves lower as well.
Let's look at an example of how this strategy can be used on a daily basis. On May 30, we got optimistic news on the housing industry. The National Association of Realtors announced that pending home sales in April rose to their highest level since 2010. This news can be seen a positive for homebuilders, so a good way to play the entire sector would on the SPDR S&P Homebuilders (XHB). This is an exchange-traded fund that focuses on the homebuilding sector.
A nice hedged trade on XHB would be the September 23/28 bull put credit spread with a 55 cent credit. In this trade, you would sell the September 28 put while buying the same number of September 23 puts for a credit of 55 cents. This trade has a target return of 12.4%, which is 39.9% on an annualized basis (for comparison purposes only). With XHB currently trading at $30.93, this trade has 7.7% downside protection.
Chart courtesy of stockcharts.com