The Perfect Trade For This Earnings Season

Jared Levy's picture

Thursday, April 30, 2015 - 10:30am

by Jared Levy

I love earnings season. The tug-of-war between earnings beats and disappointments can set the stage for some serious profits on option trades. 

I've used earnings announcements to make 40% in three weeks on Tesla Motors (Nasdaq: TSLA), 65% from Amazon (Nasdaq: AMZN) in 18 days and even 50% in Burlington Stores (NYSE: BURL) in just four days.

Just this Wednesday, I told my readers about a limited-time opportunity in Southwest Airlines (NYSE: LUV).

Most of you are probably familiar with Southwest, which has built a brand for itself as a low-cost airline. Today, it's the largest domestic carrier in the United States, based on number of passengers flown.

The company was set to report earnings before the open last Thursday, but despite a strong track record of earnings beats, shares were down more than 3.5% for the month. 

In fact, over the previous four quarters, the company had beaten expectations by an average of 10%. Better yet, in the week each of these earnings releases was announced, shares rose an average of 8%.

We saw the biggest jump in January, with LUV rising 16% the week of fourth-quarter earnings on a surprise boost from lower fuel costs. I believed we would see a similar catalyst for first-quarter earnings.

Shares of airline companies sold off on the 15% rebound in oil prices in the first few weeks of April. But while oil prices were up this month, they continued their slide in the first three months of the year, down more than 20% at one point and closing the quarter 12% lower. Since Southwest decided not to hedge its 2015 fuel costs, I expected that drop in oil prices to provide an upside surprise on first-quarter earnings.

For those investors able to look past the market's earnings neuroses, I saw an opportunity that could net them 64% profits in two months. 

Specifically, I recommended traders buy the $38 strike call options on LUV that expire in June, which we purchased for around $5.50 per share, or $550 per contract (every contract controls 100 shares).

The beauty of options is two-fold: increased leverage with reduced risk. 

These two things may sound contradictory, but consider this: When you buy an option, you are putting up less money than someone who bought the stock outright. In the case of LUV, we paid just $550 to control 100 shares of the stock, while your average investor would have paid around $4,300 if they had bought shares on the same day. Additionally, this option has the potential to return 64% on a mere 10% move in the stock.

Leading up to Southwest's earnings report, analysts had been increasing their estimates with nine upward revisions in the previous 30 days versus just two downward revisions. The consensus expectation was for earnings per share of $0.65, compared with $0.18 reported in the same period last year.

Well, when Southwest stepped up to the plate on Thursday morning, it hit a home run.

Not only did the company beat analysts' earnings expectations, but its net income of $453 million, or $0.66 per diluted share, far surpassed any first-quarter profit in its history. It also marked the eighth consecutive quarter of record profits.

The report showed a company firing on all cylinders (or turbofans, if you please). Growth was strong both here and abroad with solid traffic increases, advantageous fuel costs and route expansion adding to the bullish case.

As I told my readers, I expect the stellar Q1 report will be a catalyst for LUV to continue higher and retake its recent high of $47 before the option expires June 19. 

At $47, the call option will have at least $9 of intrinsic value (target price of $47 minus strike price of $38) no matter how much time is left until expiration, delivering a potential return of 64% in about eight weeks.

It's not uncommon for stocks to experience extreme volatility in the days following an earnings report. This means that shares can fall and/or rise rapidly, so there's still a chance you could enter the trade for $5.50 or less. And although I saw the earnings report as a potential immediate catalyst, lower oil prices, smart acquisitions and customer loyalty should help Southwest Airlines move higher long term.

Although you can still get in on this trade (as of Wednesday's market close), there's also no need to chase this trade. I am currently working on another earnings play for this week that I expect will be just as juicy. 

Earnings season is ripe with profit opportunities that can be amplified into huge gains in a matter of weeks or months with options. To prepare you for this, I put together a quick fact sheet that will introduce you to myself, Profit Amplifier and how to start recieving trades to your inbox immediately. To access that, please click here.

Jared Levy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of LUV in one or more of its “real money” portfolios.