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Earnings season is always exciting. This time around the bar is set very high with EPS growth expectations of about 8.8% YoY.
Last time around, beats were rewarded but misses were punished even harder with the average decline at about -3%. We know there were deeper discounts than that.
So with the bar raised higher this time around we’d want to be more careful trading earnings as misses may not get punished as much and rater beats may be rewarded even more.
I always put out a warning about trading earnings because it is essentially gambling. We may have an idea of what may happen but none of us know for sure how the stock will react. Even a double beat could lead to a crash in price because of unexpected guidance or something in the details.
How to Trade Earnings:
There are a few ways that you can still take advantage of earnings season, without betting on the price reaction upon release:
Run up to earnings
Quite often we see stock prices run up in anticipation of earnings. The same also happens to Options as the volatility starts to increase. Ideally, you could trade this run-up to earnings and exit prior to earnings being released.
A word of caution about options: We tend to get what is called Volatility Crush once the earnings are released so be sure to close out before that.
Remember to carefully track the earnings date and time so you don’t get caught out. Investing.com, Yahoo, and TradingView all provide earnings details and timing (i.e., before or after market).
Options
If you must bet, use options to limit your downside. With options, you know exactly how much you will lose. To further limit risk, you could also use options spreads. Again, there will be vol crush and the options will start to lose value even if you’re in the money. Please remember to close the options out as soon as possible. Mayhem has some great articles on trading options, if you’d like to learn more.
Here are the links to two great options articles:
Trade the Reaction
If you have pre-market and post-market trading, you can trade the reaction as soon as earnings come out. You can see which way the market is trading and jump in for a quick trade to ride the momentum. But please remember, price action is very volatile at that time and you will need to watch your position closely. Also, it’s best to close out the trade before the earnings call starts, which could come as early as 15-20 minutes after the earnings release.
Buy the Dip
This is probably my favorite way to trade earnings but, you have to know the stock you’re planning to buy. Quite often, the initial reaction is overdone and a stock might get sold off very hard on earnings, more than warranted. So, if it is a stock that you’ve traded often, or a company where you have a solid fundamental thesis, then this is a good way to pick up the stock at a beaten down price. You can do so by holding it as an investment or waiting until the gap is filled.
However, remember that sometimes, you need to wait until the initial price reaction shakes out. When a stock plunges so drastically, it can take some time before it starts to bounce back. So a good idea could be to buy in 25% increments of your full position size.
If you notice, I said nothing about selling the rip, i.e., shorting a stock that has an outsized positive price reaction. This is because shorting a price reaction doesn’t work out that well. Firstly, we want to hear good news about a company, and we want growth so, the price may never come to fill the gap lower and you’re going against the natural order of things. Secondly, even if it does fill the gap, it could take a really, really long time. And finally, the world is more long-only players so again, you’re going against the natural flow of the market.
My Final Bit of Advice
Be careful with earnings! The reason I like to "buy the dip" is because unless a company is terrible and worthless, there is a good chance the price will recover. Remember to take profits early…. no one ever went broke taking profits!
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