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Goldman: This trade has been a sure thing for the past 20 years

Traders in the S&P 500 stock index options pit at the Chicago Board Options Exchange (CBOE) signal.

It’s almost never a good idea to enter a trade with the assumption that it’s a sure thing. Even if the trading strategy has an unblemished record, it’s always a mistake to assume the past is somehow an indicator of future success.

Having said that, the analysts at Goldman Sachs have identified a trade that has been consistently profitable for at least 20 years.

It’s an options trade, which is a little bit more advanced than your run-of-the-mill stock trade. Specifically, the trade is to buy first out-of-the-money call options on stocks five days ahead of their earnings announcements, and then sell a day later.

In a nutshell: It’s a bet that most stocks are likely to spike upwards in response to earnings announcements.

Buying calls ahead of last quarter’s earnings yielded positive returns. (Image: Goldman Sachs)

 

“We favor call buying strategies ahead of this earnings season due to their historically strong profitability over the past 20 years and unusually high put skew that suggests investors have low expectations ahead of single stock earnings,” Goldman Sachs’ John Marshall said.

What are call options

A call option is a derivative security that gives the buyer the right to buy an asset at a certain price, or an exercise price. It’s a right, not an obligation.

An out-of-the-money call is an option whose exercise price is above the current price. For example, if an asset is trading today at $10, but the exercise price of the call is $11, then the call is out of the money by $1. There would be no advantage to exercising this option because it would make no sense to exercise the right to buy something for $11 when you can buy it on the market for $10.

A first out-of-the-money call is the option with the out-of-the-money exercise price closest to the current asset price. For example, there may be call options with exercise prices at $11, $12, $13, and $14. The $11 call is closest to the $10 current price, which makes it the first out-of-the-money call.

Options aren’t free. The seller, or writer, of these options will charge you a premium to be compensated for a number of variables include time and implied volatility.

Why has this trade has worked

The main reason why this trading strategy has worked is because the actual reported earnings of most companies tend to beat estimates put out by analysts who are forecasting earnings.

“Over the past four years on average, actual earnings reported by S&P 500 (^GSPC) companies have exceeded estimated earnings by 4.0%,” FactSet’s John Butters observed. “During this same time frame, 68% of companies in the S&P 500 have reported actual EPS above the mean EPS estimates on average. As a result, from the end of the quarter through the end of the earnings season, the earnings growth rate has typically increased by 2.7 percentage points on average (over the past 4 years) due to the number and magnitude of upside earnings surprises.”

Actual earnings usually come in ahead of expected earnings. (Image: FactSet)

And often times, a stock price will react immediately and positively to better-than-expected news.

“Last quarter, the average S&P 500 stock moved +/-3.5% on earnings day, more than 3x average daily moves,” Goldman’s Marshall observed.

Options trading is not for everyone. Furthermore, Goldman’s note offers a lot more info for clients who may wish to trade on this.

Still, it’s interesting to see these alternative ways people are making money in the financial markets.

Sam Ro is managing editor at Yahoo Finance.
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