Don’t Trade Earnings For a Short Term Gain

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Short term traders love earnings season and much like all things investing, the opinions of what to do with earnings season are as varied as the direction of markets tomorrow. Although every trader says they’re making money, are they telling the truth? Is trading during earnings season really a profitable venture?

Let’s narrow this down to one common strategy employed during this time. You pull up your earnings calendar and you notice that BP is reporting earnings tomorrow. You know that BP has been beaten down since the Gulf oildisaster and if they handily beat earnings, you could make some fast money. You purchase 100 shares of BP stock the day of their earnings announcement and wait with a bucket so that you can collect all of those dollars tomorrow!

Let’s lay out the realities of this type of trade:

The Logic

Actually, it’s the total lack of logic. If you’ve spent any time analyzing this type of trade, you know that it is virtually impossible to predict if a company will consistently beat or miss earnings estimates (without illegal insider information that is). Of course if we look at the history of earnings announcements we notice that the vast majority will beat their earnings guidance but part of that is good old fashioned marketing. Set expectations low and beat them but it doesn’t always work out, particularly if the stock price has already risen on the prospect of higher earnings.

Not only is it virtually impossible to consistently predict the contents of the earnings announcement, it’s just as impossible to predict the stock’s reaction. When a company misses earnings, their stock still may rise on the news. If a company beats earnings, their stock still might fall. Other times great earnings product little to no change. The details or future outlook in the earnings announcement can in fact be more important that the actual earnings itself. After all a stock price is the discounted value of future earnings, not past earnings.

There are ways to up your chances of doing the impossible. Some investors say to look at the put/call ratio and look for stocks that don’t have high expectations of greatness. (Look at the charts and find a stock that has moved sideways or steadily down) If you’re an options trader, you’re looking at the implied volatility to see how much of a move is priced in to the option.

These strategies help your chances of getting it right but putting a trade on that is tied to an earnings announcement isn’t much more scientific than going to the horse track regardless of how many articles you read. Further, the required analysis is beyond the average retail investor (and that’s why the pro’s make more money than the rest us of)

The Gap

Here’s the next problem with this type of trade. You are setting yourself up to be a victim of the gap. Let’s say that our BP stock closes at $40.00. Then, following the market close, BP announces a worse than expected earnings report and the stock falls to $36.00 during the after-hours. Unless you are going to trade in the afterhours market, your stock opens at $36.00 the next morning and you were powerless to do anything about it. Your carefully crafted stop orderis worthless because the stock “gapped down” $4. Of course, it could gap up in your favor as well.

The facts

So far we’ve offered some opinions based on nothing more than observations but let’s look at a report that was prepared on this very subject. Rocky White, Senior Quantitative Analyst at Schaeffer’s Investment Research looked at trends to try and find a way to play the odds of this trade. He looked at 12,000 earnings announcements and the trends leading up to the announcement. (Wonder how long that took?)

What he found is this: For stocks that had a decline of 10% or more, 21% had a surprise announcement that resulted in a gain of 10% or more and 57% of those big pre-earnings losers had a positive earnings report. Statistics show that if you want the best chance of catching the big gain, play the stocks that lost a lot of value during the five days prior to the announcement.

But let’s be careful with this exciting news. If 21% had big gains and 57% beat earnings, that means there were still 43% of those big losers that remained losers and 79% either lost money or might not have moved enough to justify the risk. If we look at these figures, this earnings trade isn’t looking very attractive.

The Upside

Although nothing seems to be in our favor, there is a bright side. We know that traders don’t have to win on every trade to make money. In fact, one good trade can easily wipe out a series of losses from bad trades and still make a profit.

Let’s say that you found 5 stocks that had losses of 10% or more during the 5 days prior to their earnings and you started a position in each of these names. If we believe Rocky’s statistics above, at least half of these trades are going to produce small gains or possibly small losses and one of the five will produce a gain of 10% or more. At most, 5 of those trades will produce significant losses but unless you’re caught in the gap, you can mitigate those losses with a carefully crafted “one cancels the other” order.

The Better Way to Play

Those who have the gift of patience play earnings another way. They use earnings as valuable information in which to form a medium term forecast for the company. Using that information, they can make a judgment based on that information. If the stock had a big jump of 10% or more, the earnings information along with listening to the conference call, allows the trader to make an educated judgment if the stock will give back that 10% gain or continue upwards.

This type of strategy is based on sound analysis and often serves to produce more consistent, yet possibly less exciting results. You probably won’t make 10% in one day but over a week or month, that 10% could easy by seen. The other advantage of this trade is that you never find yourself a victim of the gap. You can set tight limits and stops so you control your money.

Probably the better way to play earnings is to use the options market. Options traders can use a strategy known as a strangle where the trader profits when the stock goes up or down. The only way money is lost is if the underlying stock barely moves. This is an advanced strategy and the stock trader is advised to not try this until it has been practiced.

The Bottom Line

There are a lot of people who trade earnings but any time a strategy of quick profits is employed, the chances of making money consistently over the longer term are not in the trader’s favor. The only thing we can predict for sure in today’s highly linked and global markets, is that they will be volatile.

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