The Momentum Trade With Options in Restoration Hardware Holdings Inc
Restoration Hardware Holdings Inc (NYSE:RH) : The One-Week Pre-earnings Momentum Trade With Options
Date Published: 2018-06-04Disclaimer
The results here are provided for general informational purposes, as a convenience to the readers. The materials are not a substitute for obtaining professional advice from a qualified person, firm or corporation.
PREFACE
Last earnings cycle, RH stock gapped higher on the results,popping from $75 to $92 in one day. That move, combined with a bullish momentum pattern in Restoration Hardware Holdings Inc (NYSE:RH) stock 7 calendar days before earnings, creates a window of opportunity to back-test.
According to our data provider, Wall Street Horizon, RH has earnings due out n 6-11-2018 after the market closes, so 7-days before then would be 6-4-2018. Also, here's a quick look at the last earnings gap higher, for context.
This same strategy also worked in the throes of the bear market from 2007-2008, and we discuss those results near the finale of this article.
LOGIC
The logic behind the test is easy to understand -- in a bull market there can be a stock rise ahead of earnings on optimism, or upward momentum, that sets in the one-week before an earnings date.
Even further, we have empirical research that supports the idea that if the prior quarter move off of earnings was a large upward move, that the next quarter's pre-earnings momentum tends to be greater.
We will examine the outcome of getting long a weekly out of the money (40 delta) call option in Restoration Hardware Holdings Inc 7-days before earnings (using calendar days) and selling the call before the earnings announcement.
Here's the set-up in great clarity; again, note that since RH reports earnings after the market closes, this back-test closes before earnings, so this trade does not make a bet on the earnings result.
RISK MANAGEMENT
We can add another layer of risk management to the back-test by instituting and 40% stop loss and a 40% limit gain. Here is that setting:
In English, at the close of each trading day we check to see if the long option is either up or down 40% relative to the open price. If it was, the trade was closed.
RESULTS
Here are the results over the last two-years in Restoration Hardware Holdings Inc:
The mechanics of the TradeMachine® Stock Option Backtester are that it uses end of day prices for every back-test entry and exit (every trigger).
Track this trade idea. Get alerted for ticker `RH` 7 days before earnings
We see a 626.2% return, testing this over the last 8 earnings dates in Restoration Hardware Holdings Inc. The trade will lose sometimes, but over the most recent trading history, this momentum and optimism options trade has won ahead of earnings.
Setting Expectations
While this strategy had an overall return of 626%, the trade details keep us in bounds with expectations:
➡ The average percent return per trade was 73.7% over each 7-day period.
➡ The average percent return per trade was -46.6% over each 7-day period.
DIGGING DEEPER
We can run this same back-test but set an even stricter entry rue -- only test buying the pre-earnings call if and only if the prior move off of earnings was a 3% gain or more.
And here are those results, over the last 2-years:
Now we see that the pre-earnings momentum trade only triggered 3 times out of the last 8 earnings cycles, but in this back-test, it was a winner each time and the average return per 7-day period was 103%.
Is This Just Because Of a Bull Market?
It's a fair question to ask if these returns are simply a reflection of a bull market rather than a successful strategy. It turns out that this phenomenon of pre-earnings optimism also worked very well during 2007-2008, when the S&P 500 collapsed into the "Great Recession."
The average return for this strategy, by stock, using the Nasdaq 100 and Dow 30 as the study group, saw a 45.3% return over those 2-years. And, of course, these are just 8 trades per stock, each lasting 7 days.
* Yes. We are empirical.
* Yes, you are better than the rest now that you know this.
* Yes, you are powerful for it.
WHAT HAPPENED
There's a lot less luck to successful option trading than most people realize. Now it's your turn; we welcome you to watch this quick demonstration video:
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Risk Disclosure
You should read the Characteristics and Risks of Standardized Options.
Past performance is not an indication of future results.
Trading futures and options involves the risk of loss. Please consider carefully whether futures or options are appropriate to your financial situation. Only risk capital should be used when trading futures or options. Investors could lose more than their initial investment.
Past results are not necessarily indicative of future results. The risk of loss in trading can be substantial, carefully consider the inherent risks of such an investment in light of your financial condition.
Please note that the executions and other statistics in this article are hypothetical, and do not reflect the impact, if any, of certain market factors such as liquidity and slippage.