About Us
Disclaimer

Speculative Investing Strategies


An Overview of Speculative Strategies

Speculative Investing Strategies - picture of an overview of speculation with a laptop computer switched on with the screen showing trading in big red capital letters

There are numerous speculative strategies that are utilized by market participants within the stock market. Some strategies are fairly straight forward while others are quite complex. Some strategies are quite easy to implement while others take a considerable amount of effort. There are strategies which are fairly low risk and others which are high risk.

Some of the speculative strategies are suitable for investors and others are more suited to trading. Generally most speculative investing strategies are more suited to short-term and medium-term investing time frames with very few being appropriate for long-term investing. The speculative investing strategies incorporate risk analysis tactics to manage the risks involved.

The speculative trading strategies tend to involve longer time frames than those utilized by technical traders such as swing traders and position traders. Speculative traders generally combine fundamentals with technical analysis as opposed to technical traders who typically focus solely on the stocks price history.

Most of the speculative strategies focus on the smaller companies as they have more potential than their larger cousins.

Some of the common speculative strategies revolve around small-cap growth stocks. These are stocks which have the potential to significantly growth their revenue and earnings. Indeed some of these small-cap growth stocks will be tomorrow's industry leaders. Any investor who buys into these stocks early will be handsomely rewarded in the future years.

Speculative traders are extremely active with small-cap growth stocks as they speculate on the strong uptrends these stocks frequently display.

Another popular strategy utilized by stock investors is value investing which provides good long-term returns. However speculative investing with small-cap value stocks which have growth potential can provide exceptionally good returns. These returns can be further boosted by short selling put options as a means of acquiring value stocks and collecting the option's premiums.

Speculative traders make good use of small-cap value stocks who trade them based on the typical stock price behavior of fluctuating above and below the company's fundamental valuation.

Other strategies seek to obtain the short interest fee charged to short sellers who borrow stock. This short interest strategy involves loaning stock to the short seller and collecting the short interest fee.

The earnings season provides the speculative trader with opportunities. Speculating on an earnings release which is unlikely to exceed the expectations of the market participants is a popular strategy utilized by speculative traders.

Some speculative traders short sell financially distressed stocks facing bankruptcy. The Z-score is a popular indication of potential bankruptcy which speculative traders use.

There always new strategies being developed and old strategies which are no longer used. Speculation is only limited by the imagination of the market participant.

Generally most speculative strategies are not suited to beginner investors or beginner traders. While most strategies are not difficult to implement, any market participant who does not have a sound knowledge of the working dynamics of the stock market will likely run into trouble with most speculative strategies. This also includes technical trading for that matter.

It is best if the beginners spend time educating themselves first before attempting any speculative strategies. When first incorporating any speculative strategies it is generally recommended that only a portion of the account be allocated to speculative strategies and the balance allocated to sound long-term investing strategies.

Small-Cap Growth Stocks

These are a favorite with investors - high return but also high risk

Speculative Investing Strategies - Small-Cap Growth Stocks; picture of an investor pointing to stock chart that is trending higher with a pen in his hand

Growth stocks attract the attention and imagination of market participants and these growth stocks with their revenue and earnings growing at an above average rate lead to some significant increases in their fundamental valuations and their stock price gains can be nothing short of spectacular. The famous investor - Peter Lynch made good use of small-cap growth stocks in his mutual fund portfolio.

While any size company can significantly grow, it is the smaller sized companies that have the most growth potential. These smaller companies are generally referred to as small-caps and any such stock which is significantly growing attracts a flood of speculative market participants who through their own buying demand can send stock prices to ridiculously overvalued levels.

Speculating with the future growth of small-cap stocks is what defines the stock market. These small-cap growth stocks are the high gain and high risk stocks that attract the attention of the financial press. They are the same stocks that the financial press reports on when investors lose 90% of their money.

Small-cap growth stocks are fueled by bull markets and their number one enemy is the bear market. For when a bear market comes along, any investor still holding these stocks will know about it when their stock prices come crashing down. Small-cap growth stocks are heavily reliant on a bull market. In bull markets, investors are willing to pay extremely high prices for future earnings, but in bear markets they are no longer interested.

Investing in small-cap growth stocks can also be referred to as Momentum investing, Small-cap investing and Speculative investing.

The high momentum that these small-cap growth stocks can generate attracts technical traders such as swing traders and position traders whose only interest in the stock is that it is in a strong uptrend. Technical traders find these stocks through scans and their participation further fuels the uptrend.

Speculating with small-cap growth stocks is safest when the stock is of investment grade. This can be with its existing valuation or by speculating on an increasing valuation. Speculative grade stocks are a higher risk, but if the investor correctly speculates on an increasing valuation then the rewards can be significant.

Speculating with the valuation increase with a small-cap growth stock of investment grade is illustrated below in Figure 1.

Figure 1. Speculating with an investment grade

Small-Cap Growth Stocks - Speculating with investment grade stocks, chart showing stock price inceasing with valuation

Speculative investing is extremely popular with small-cap growth stocks but it is also one of the highest risk strategies there is. This is not because the increasing fundamental valuation is a high risk, but because investors typically pay such high prices. Usually as soon as a small stock starts growing, the stock price is already overvalued and becomes increasingly more overvalued as the uptrend progresses.

The risk can be reduced by selecting stocks that are reasonably priced. With growth stocks a good valuation method to use is the PEG ratio (price earnings growth). A stock is reasonably valued when its PE ratio (price earnings) is somewhere near its annual earnings growth rate.

An example of an investment grade small-cap growth stock is Dorman Products, Inc. The company has a solid history of revenue and earnings growth as shown below in Table 1.

Table 1. Increasing Revenue and Earnings Trend

Small-Cap Growth Stocks - Table 1 showing data for Increasing Revenue and Earnings Trend

As the above table shows, Dorman Products, Inc. has shown solid revenue and earnings growth. The stock chart is shown below in Chart 1.

Chart 1. Small-Cap Investment Grade stock

Small-Cap Growth Stocks - Chart showing how stock price continues upwards for investment grade stock over the long term

As the above chart for Dorman Products, Inc. shows, the stock price has generally increased over the last decade in line with its growth in earnings. The stock did plunge during the first halve of 2014 but has since recovered and is currently trading at new highs.

As a general rule speculating with small-cap growth stocks is not suitable as a buy and hold investment due to the high probably of a dramatic reversal. Incorporating an exit strategy will at least save the speculative investor from the inevitable plunging stock price once the bull market ends. These small-cap growth stocks are also highly susceptible to sharp corrections when reported earnings disappoint or when the release of any information which indicates that growth may be slowing.

Speculative Investing Strategies - Small-Cap Growth Stocks; picture of a ythree dimensional sign saying risk in big red capital letters on a light blue background

Combining small-cap growth stock with a stop-loss strategy has its advantages and disadvantages. The obvious advantage is that when the stock peaks and reverses its uptrend then the investor can lock in a substantial profit by exiting nearer to the top. The disadvantage is the speculative investor can be prematurely stopped out. The speculative investor can however always re-enter the stock should the uptrend continue.

As bear markets are detrimental to growth stocks, the speculative investor can also monitor the current market conditions for any signs that the bull market may be ending. A useful technique is that provided by Dow Theory as this at least alerts the speculator that the bull market may have ended. If the signal provided by Dow Theory proves to be false, then the speculator can always re-enter their position.

Utilizing a stop-loss strategy effectively merges investing with trading. This is a speculative investing style made popular by William O'Neil. The stop-loss can be as simple as a percentage decline from the current price or can be more involved by incorporating technical analysis techniques. In fact whenever an investor views a stock chart to study its trending nature they are in effect conducting a basic analysis of the stock's price history, which is basic technical analysis.

The argument presents itself whether a speculative investor who incorporates a stop-loss strategy is in fact trading rather than investing. While it is debatable, if the speculator follows the stocks fundamental growth they are still investing. However if the speculator focus heavily on the stock price then they are more likely becoming a trader. This is especially true if they start to speculate that the stock price has reached its peak. Bull markets can carry stock prices to insanely overvalued levels.

Speculative trading uses the fundamental growth as an analytical tool in order to determine which direction the valuation will likely head in. An increasing fundamental valuation means that stock prices will broadly fluctuate in that general upward direction. This favors a long-side trade for most speculative strategies.

Speculative traders are extremely active on the long-side with small-cap growth stocks, but unlike the speculative investor who is concerned with the ongoing valuation increase, the speculative trader is only concerned with the stock price movement.

Speculative traders look for a fundamental reason why they should speculate on the stock price increasing while speculative investors look for the fundamental valuation to increase. Speculative traders are sometimes referred to as fundamental traders and generally have shorter time frames than speculative investors.

The entry and exit tactics used by speculative traders vary significantly but they are generally based on technical analysis with chart patterns being extremely popular.

The series on Chart Investing gives the speculator numerous examples using charts as the primary means of tracking the stock price.

The series on Position Management gives the speculator numerous examples using stop-loss techniques that are suited to the longer time-frames of speculative investing.

It is generally safer to speculate with a fundamentally sound stock with an investment grade being preferable. Obviously to be considered a growth stock it must be growing its revenue and earnings, but the growth rate is arbitrary. Ideally speculators conduct a broad industry analysis to locate a stock which is growing faster than the industry. However the entire industry might be growing faster than the overall economy is growing which means there are a variety of stocks with good growth prospects with that industry.

Speculative Growth Stocks

Getting in before the crowd

Speculative Investing Strategies - Growth Stocks; picture of a stock earnings bar chart with an increasing trend higher for traders to profit from

While it is certainly profitable when the speculative investor selects a small-cap growth stock which continues with its uptrend, it is even more profitable when the speculative investor selects the same stock before it became a growth stock. This was a favorite tactic of the famous investor - Peter Lynch.

While market participants keenly speculate on small-cap growth stocks, there are plenty of speculative investors willing to speculate on a stock which currently has little or no growth history but has significant potential to grow in the future. These pre-growth stocks are the classic speculative growth stocks.

Selecting tomorrow's new growth stock is considerably more difficult than merely finding a stock which is currently growing. However, a stock which has not yet begun it's grow is still trading at fairly cheap price relative to its valuation. In fact such a stock provides a good chance to buy below its fundamental valuation. This means that should the stock become tomorrows growth stock and thus it typically becomes overvalued fairly quickly, the speculative investors gain is significant and this is when the speculative growth investors first start to participate. The subsequent gains are nothing short of spectacular.

Thus it's not hard to see why these potential small-cap growth stocks are popular with speculative investors, but like any investing strategy - high rewards come with high risks. The chances of a speculative investor picking tomorrow's growth stock are quite slim. This means a lot of stocks will not grow their revenue and earnings as anticipated. That does not necessarily make then a bad investment, but their future valuation increase will likely be minimal.

Speculating with the valuation increase of a small-cap speculative grade stock which is financially stable but has not yet grown its revenue and earnings is illustrated below in Figure 1.

Figure 1. Speculating with a small-cap

speculative grade stock

Growth Stocks - graph showing Speculating with a small-cap speculative grade stock price increasing trend

An example of a Micro-cap stock which is financially stable but has plenty of potential to grow its earnings is Castle Brands, Inc. Its revenue and earnings history are shown below in Table 1.

Table 1. Increasing Revenue but No Earnings

Speculative Growth Stocks - Table1 showing earnings trend with Increasing Revenue but No Earnings

As shown in Table 1. above, Castle Brands, Inc. has revenue growth but has no earnings growth and ultimately the stock price follows its earnings. However, in the company's favor the brokers recommendation is for a strong buy and the analysts forecasts have the earnings turning positive in 2017 with earnings of $0.01 and earnings of $0.02 in 2018.

Yes this is a highly speculative stock, but should Castle Brands, Inc. turn a profit its stock price could potentially sore.

The stock chart for Castle Brands, Inc. is shown below since listing.

Chart 1. Stock Price since Listed

Speculative Growth Stocks - Chart showing stock price drop over the long term for company with no earnings

As the above chart for Castle Brands, Inc. shows, the stock listed and then just plunged - no doubly due to its inability to make a profit. This does however show what investors will pay if they think the company can make a profit. Should the forecast future profits emerge then the speculator would have hoped on broad early and enjoyed a nice run up in the stock price.

The investment risks are reduced when speculating with investment grade stocks. If the earnings growth increase does not emerge, at least the earnings are still growing slowly. An investment grade stock is currently growing its earnings but the grow rate may only be minor and just keeping pace with the growth in the economy. While this does not reduce the risk of the stock not growing, at least there is still some earnings growth if the anticipated increase does not emerge.

Speculative investing on future earnings growth generally works best during bull markets. A convenient method of determining the current market cycle is that provided by Dow Theory.

For stocks that succeeded and became growth stocks, the speculative investor might decide to exit their position or at least reduce their exposure when the markets show signs that the bull market might have ended. The Dow Theory signals can be used for this. If the signal proves to be false then the speculative investor can always re-establish their positions.

Speculative Investing Strategies - Growth Stocks; picture of two investors holding a tablet with stock price data shown and an earnings chart to analyze for a profitable trade

With stocks where the growth did not emerge, the speculative investor may wish to remain invested after a bull market has ended, but may well prefer not to enter any new positions during a bear market. Again the Dow Theory signals are convenient for this.

Small-cap stocks with future growth potential also attract the attention of speculative traders. They generally base their entry positions on the basis of the stock breaking out to new highs as observed on a stock chart. This reasoning is sound as any stock which becomes a growth stock will see its stock price sore to new highs. These speculative traders seek to buy these stocks as soon as they break out of their existing broad trading range.

Speculative traders will typically utilize risk management tactics such as implementing an initial stop-loss and a subsequent trailing stop. Speculative traders generally seek a larger portion of the ensuing uptrend than what position traders are seeking and thus typically employ wider stops to give the stock more room to move so as not to be stopped out too frequently.

Speculative traders with their risk management strategies tend to be more speculative than investors. They tend to include more speculative grade stocks even with fairly poor fundamentals so long as there is significant future growth potential.

Some speculative investors utilize some of the speculative trading tactics such as waiting for the stock to break out to new highs before taking a position and employing an initial stop-loss. These speculative investors will frequently then follow any subsequent increase in the fundamental valuation rather than use a trailing stop. Thus they have incorporated some technical analysis tactics in amongst their investing strategies.

The advantage of incorporating an initial stop-loss is that the speculative investor can readily exit any stocks which are not growing. However the disadvantage is that the speculative investor accumulates a large portion of small losses.

The series on Position Management gives the speculator numerous examples using stop-loss techniques that are suited to the longer time-frames of speculative investing.

Irrespective of the tactics employed, speculating on the potential future growth of a stock works best when the markets are bullish and are best avoided when markets are bearish.

Value Trading

Value investing for the impatient investor

Speculative Investing Strategies - Value Trading; picture of a trader using a calculator to work out the trade to take while sitting in front of a computer screen

Value trading is simply a speculative trading version of value investing which seeks out stocks that are trading below their fundamental valuation. The strategy basically involves buying stocks for less than what they are worth and selling them at a higher price. Thus unlike value investing, the speculative trader is only interested in the stock price movement and is not interested in any future increase in fundamental valuation.

The basic principle of value trading is straight forward and is based on the fact that stock prices fluctuate about considerably and spend more time above than below their fundamental valuation.

While any stock can be used with value trading, companies where their fundamental valuation is increasing or at least expected to increase are safer stocks to speculate on.

Market capitalization is not specifically a factor with value trading, but most large-cap stocks spend most of their time above their fundamental valuation and about the only time they even come close to their fundamental valuation is during bear markets or when they are experiencing short-term financial problems. Simply put there is just too much demand for these large-cap stocks.

It’s easier to find small-cap or mid-cap stocks

trading below their fundamental valuation

The small-cap and mid-cap stocks provide more opportunities for speculative traders as there is less demand for these stocks and less or even no involvement from institutional investors. Small-cap stocks can be sold down well below their fundamental valuations and even sold below their tangible book value with fundamentally sound companies. This makes small-cap stocks a favorite hunting ground for this bargain basement speculative style of trading. Value trading is sometimes referred to as buying "stocks on sale".

Small-cap stocks that are of investment grade are the safest stocks to value trade, but speculative grade stocks which are basically financially stable are also possible candidates especially if their future prospects are good. The main consideration is that the fundamental valuation is not expected to decline as this significantly increases the risks with value trading.

Speculative value trading with a small-cap speculative grade stock which is financial stable with good future prospects is illustrated below in Figure 1.

Figure 1. Speculative value trading with a small-cap

speculative grade stock

Value Trading - Speculative value trading with a small-cap speculative grade stock with price increasing in the future

Value trading with fundamentally sound companies is actually one of the lowest risk strategies. A lot of beginner value traders get caught out and simply buy small-cap stocks where the stock price has significantly declined.

The problems these beginner value traders encounter are twofold. First the stocks they pick are typically financially distressed which means their future fundamental valuation is likely to continue downwards and secondly they still tend to buy above their fundamental valuation. Just because the stock price has fallen from $20 to $10 does not make it a value stock as the fundamental valuation may only be $8. To make things worse the fundamental valuation next year might only be $7 and the year after that only $6. It is much safer to only select companies where the fundamental valuation is increasing or at least stable with future potential to increase (declining fundamental valuations are high risk).

An example of a fundamentally sound small-cap investment grade stock is shown below in chart 1. for Innospec, Inc.

Chart 1. Value Trading - Fundamentally Sound Stock

Value Trading - stock Chart showing value when to buy at good price over the long term

Innospec, Inc. shown above in Chart 1. was trading with a forward PE ratio of 8.8 and a forward PEG ratio of only 0.4 during April 2016. The company's book value has been increasing over the years and is currently around $27. The fundamental valuation for this stock based on its earnings growth is around $100 with a forward PEG ratio of 1.0.

Speculative Investing Strategies - Value Trading; picture of a stock trader pushing a button on a large glass panel with the words risk management for speculation trade

There are no formal guidelines for how far below the fundamental valuation a value trader should buy stock. Basically the number of trading opportunities decreases as the stock price drops further below its fundamental valuation. In other words, the greater the discount is then the fewer the opportunities which are available.

A general guide suggested by Benjamin Graham (who made good use of hedge fund trading tactics) is to buy 33% below the fundamental valuation. This is based upon the idea of providing a margin of safety so that even if the value trader's evaluation proved incorrect there is at least a buffer. What this means is that if the fundamental valuation was determined to be $15 but in fact turned out to be more like $12, the value trader having bought at $10 still bought below what it was worth. Note that the fundamental valuation is the value that the investor has determined the stock to be worth and is not the book value.

Unlike most value investors, value traders typically incorporate technical analysis techniques into the decision making process as their intention is to profit from that stock's price increase and are not concerned with its fundamental valuation increasing over time.

Bull markets favor most trading strategies and value trading is no different. One of the simplest methods of determining whether the market is bullish or bearish is with Dow Theory. Value trading works best during bull markets but there are exceptions.

There are several entry techniques that value traders utilize.

A simple entry is a bounce entry where the stock price rebounds after being sold down. This is a form of bottom picking and an initial stop-loss is placed below the Relative Low of the bounce. This tactic tends to be stopped out frequently with small losses but sooner or later the actual bottom is reached and the stock then rallies.

The series on Position Management gives the speculator numerous examples using stop-loss techniques that are suited to the longer time-frames of speculative investing.

Some value traders incorporate chart patterns and enter once a bottom pattern is completed. Other value traders prefer to use chart indicators. These are personal choices and there are no hard and fast rules.

The series on Chart Investing gives the speculator numerous examples using charts as the primary means of tracking the stock price.

Value trading is one of the few exceptions where speculative traders can actually get away without using an initial stop. With this variation to value trading, a profit target is selected which might be 100% above the entry price. This means that the stock is either sold for a 100% profit or the company goes into bankruptcy and the stock is worthless thus losing 100%. In other words, the value trader either makes a 100% profit or losses 100%. With fundamentally sound companies the chance of bankruptcy is fairly low. The downside with this approach is that it can take years for the stock price to reach its profit target, but it is a method favored by speculative traders who think more like investors.

Value Trading with Short Options

Earn an income while value trading

Speculative Investing Strategies - Value Trading with Short Options; picture of a value trader looking at stock price screen on a computer while sitting down at a desk

Incorporating stock options with value trading is an advanced version which increases the potential profitability of trading and/or investing with value stocks.

Typically the value investor or value trader will buy stocks below their fundamental valuation. Thus these market participants are the bargain hunters and are only interested in acquiring stock at prices that are less than what they are worth.

As a bonus, value stocks which pay a dividend provides the value investor or value trader with an additional profit.

Value investors and value traders can further boost their profit by using a stock options tactic known as short selling options.

While many consider short selling options to be a high risk options trading strategy, the value investor or value trader are in a unique position. When a short put option is assigned, the short option holder must accept the stock and pay the long option holder the strike price. This often causes problems for options traders, but for the value investor or value trader this is to their advantage.

Value investors and traders can short put options to

buy stock and also receive the option premium

The value investor or value trader can place market orders to buy stock, but will often place a buy Limit Order for stock at a limit price that is below the current price and wait and see if the stock trades down to their limit price. If the stock trades at the limit price then the buy order is filled. If the stock does not reach the limit price then the order is not filled.

Short Put Options to buy stock

Placing a buy Limit Order is not the only way to buy stock. As an alternative, the value investor or value trader can instead short sell a put option with a strike price equal to the limit price that was selected. If the stock trades down to the strike price then the option is assigned and stock is received and the cost is the strike price. If the stock does not reach the strike price then no stock is acquired.

Speculative Investing Strategies - Value Trading with Short Options; picture of two stock traders talking on a phone to an investor while working on a computer for value stocks to trade

Thus the end result with short selling put options is essentially the same as placing a buy Limit Order.

The advantage with short selling put options to acquire stock is that the value investor or value trader receives the option premium irrespectively of whether they acquired the stock or not. If the stock was not acquired then the value investor or value trader will get more chances to acquire the stock, each time they receive the option premium for trying to buy the stock.

It is important to note that this option tactic is specifically intended for value investors and value traders who are buying stock below its fundamental valuation and below the current stock price.

The selection of the strike price is up to the individual. The option premium received (time value component) is the greatest when the strike is At-The-Money and there's roughly an equal chance of acquiring the stock. If stock is not acquired the first time then there's a good chance it will be acquired the second time (and receiving the premium for the second time).

As the strike price goes further Out-The-Money the premiums received drop significantly and the chances of acquiring the stock also decreases. Also, Out-The-Money Put options can be difficult to sell as they may not have a bid price. This means that a Limit sell order must be used and there's no guarantee that the order will be filled.

Usually the stock price is not exactly at a strike price, therefore the value investor or value trader will normally need to select the next available strike price. Usually selecting strikes Out-The-Money is generally preferred to In-The-Money but this is a personal choice.

The general rule is that the further the strike price is below the current stock price then the lower the chance of acquiring the stock.

As an example, Sunono Logistics Partners is a stock that is currently trading around its book value at $25 and has formed a new uptrend. The stock chart is shown below in Chart 1.

Chart 1. Stock with a New Uptrend

Value Trading with Short Options - stock chart showing trader when to buy using options in new uptrend

A value trader might speculate that Sunono Logistics Partners new uptrend will continue and the trend-line will act as a support. The stock has a selection of put options avaliable. However, all the Out-The-Money Put options do not have a bid for the current month's expiry - which means that the value trader cannot place a Market order to short sell them.

The value trader can:

  • Short sell with a Limit sell order - an Out-The-Money current month expiry Put Option and receive around $0.45 per share for a $23 strike if the order is filled.
  • Short sell with a Limit sell order - an At-The-Money current month expiry Put Option and receive around $0.55 per share for a $25 strike if the order is filled.
  • Short sell with a Market sell order - an At-The-Money current month expiry Put Option and receive around $0.35 per share for a $25 strike. A Market order ensures that the order is filled.
  • Consider short selling next month's expiry Put options which do have Bid prices for the Out-The-Money Put options.

Note: Put Options are sold in 100 share lots.

Short Call Options to sell stock

Value traders who use a profit target will typically place a sell Limit order. The same tactic of short selling options can be used instead of placing a sell Limit Order for the stock. This time a short call option is used which requires the short option holder to deliver stock to the long option holder and in return they receive the strike price for the stock. In other words, stock was sold for the strike price and the result is exactly the same as if a limit Sell Order were used. Thus the value trader sells their stock at their profit target and also receives the option premium.

Speculative Investing Strategies - Value Trading with Short Options; picture of a stock investor on a phone to a broker to place a trade while looking at charts on a computer screen

Since the stock can take some time to reach its profit target, the value trader keeps receiving the premiums each time the short call option is sold.

Generally options with the shortest expiry date provide the highest premium for the time duration. This is because the time decay is the greatest in the final weeks before expiry

This exit tactic is really only suitable for value traders who sell their value stocks at the profit target. It is not generally suitable for buy and hold value investors or even value traders who employ trailing stop-loss tactics rather than profit targets.

The big advantage of utilizing short selling options to buy and sell stock is that of the option premiums received. This is especially the case with selling stock as it can take considerable time to reach its profit target and the value trader effectively receives an income while waiting for their stock to be sold.

The disadvantage of short selling options is that not all stocks have options, especially speculative grade stocks. If the stock does have options the strike prices may not be at the same level as the profit target. The only solution here is to select the profit target so it matches a strike price.

The only real risk for the value trader is in short selling the wrong option direction.

Value trading with options:

  • To buy stock, a put option is short sold.
  • To sell stock, a call option is short sold.

The value trader needs to be clear as to which short option does what, as getting the wrong direction will cause problems. But in all fairness this is the same as accidentally placing a buy order instead of a sell order when trying to sell stock.

Overall, using short options to buy and sell stock provides a means of potentially boosting the returns from value trading in excess of simply using stock Limit Orders. The problems option traders encounter can be used to the value trader's advantage.

Earnings Season Strategies

It's the season to profit

Speculative Investing Strategies - Earnings Season; picture of two investors checking the earnings season results using accounting techniques for analysis of stock prices

The earnings season presents the speculative investor with some unique opportunities as it is during these times that some of the biggest stock moves occur.

The date of the earnings release is known well in advance as it is the date that the form 8-K is scheduled. Companies report their earnings on the form 8-K and it is common for stocks to rally or decline based on earnings forecast estimates on the lead up to the earnings announcement. Stock prices will often move even further based on whisper numbers.

The stock market is ripe with speculation as to what the earnings result will be. Market participants are more than willing to speculate and pay for higher earnings well before they have any proof of those earnings. Similarly they are more than willing to sell their stocks at ridiculously low prices on the fear that the earnings result will be poor and they do so before they have any proof.

An example of a stock that initially sold down hard and then slowly climbs before the earnings release is with Nike shown below on chart 1.

Chart 1. Earnings Disappoint and Stock Rallies

Earnings Season Strategies - stock Chart showing company with Earnings Disappoint and Stock Rallies higher after buying

Nike's reported earnings were significantly lower than the previous quarters and the stock bounces a few days later and starts to rally. The speculative investor can hop on board for a quick sharp rally.

Rallies from earnings releases are usually fairly short lived and the stock's fundamentals and market conditions will then take over.

Another popular tactics used by speculators is locating stocks which have rallied significantly in the lead up to the earnings announcement. These stocks have accumulated of a lot of investors keen to hop on board the rally for fears that they will miss out.

Their buying causes the stock to rally further and the short-term market participants such as swing traders and position traders are attracted to the stock's rally. Once the earnings are released, if the result is not significantly greater than what was expected, those investors are disappointed and tend to sell thinking that they made a mistake. This triggers the stop-loss levels of the technical traders which adds further supply and fuels the sell-off.

Once the earnings are announced and they are as

expected, there′s nothing left to speculate on

Basically the only way a stock with a strong rally leading up to the earnings announcement will continue to rally is if the earnings result exceeds all expectations or if the next earnings result is forecast to be even better.

A tactic used by speculative investors is to short sell stock or buy a put option the day before the earnings are due to be released. This is illustrated below in Figure 1. with a financially distressed speculative stock which rallied on the lead up to its earnings announcement.

Figure 1. Speculative trading with a small-cap

speculative grade stock

Earnings Season Strategies - Speculative trading with a small-cap speculative grade stock with uptrend turning to down trend

Buying put options has the advantage of a limited loss (which is the amount paid for the option) should the earnings result exceed expectations and the stock continues to rally.

If the earnings result matches the forecast or even better if it disappoints, then the stock will most likely sell-off and the put option increases in value which is sold prior to its expiry.

The disadvantage with buying put options is that of time decay which works against the option buyer. One way to reduce the effect of time decay is to buy longer dated options and sell them well before expiry. This is because time decay is the most significant in the final weeks before expiry. Another consideration with options is the Bid-Ask spread which can be quite significant with some options. Wide Bid-Ask spreads are generally best avoided as there is too much slippage which affects the risk-reward.

While there is no time decay when short selling stock, there is the short interest payment cost that needs to be considered. Short selling stocks is generally a higher risk tactic. There is no limit as to how far the stock could rally should the reported earnings exceed expectations.

Speculative Investing Strategies - Earnings Season; picture of an investor working on a laptop computer checking the earnings results over the internet with stock charts

Speculating on an earnings release that meets or disappoints expectations can be performed on any stock. It does not really matter if the stock is of investment grade or speculative grade. The main criterion is that the stock has rallied to such an extent that the forecast earnings cannot even come close to justifying the stock price increase.

A lot of speculative grade stocks do not have analyst forecasts. The same concept is applied but the prior earnings growth rates are used as a guide to determine if the rally leading up to the earnings release is excessive.

This creates an issue with financially distressed stocks which have no earnings growth or even earnings for that matter. A company with continuous prior year losses is difficult to gauge whether a rally leading up to earnings release is excessive or not. That makes these stocks a much higher risk as the speculative investor has to make a judgment. However, any significant rally implies that a great earnings result is expected and if the reported result disappoints, these financially distressed stocks can be sold down heavily.

Some stocks sell-off heavily in the lead up to their earnings release. This is the other extreme to stocks rallying and market participants are selling stocks on the fear that the results will be poor and they simply want to get out of their positions at any cost.

The speculative investor uses the same tactics as with rallying stocks. They can either buy stock or a buy a call option.

Buying call options has the benefit of having a limited loss but has the time decay issue. Buying stocks has the advantage of no expiry which can be beneficial should the stock rally beyond the expiry date of an option.

There is a lot of speculation leading up to the earnings release which a speculative investor could participate with, as an alternative the speculative investor can benefit from an earnings release which is unlikely to exceed the expectations of the market participants.

Blog Articles