Smart Tips And Crafty Tricks For Trading During Earnings Season
- Second quarter earnings season starts next week and will unwind over the following month. Generally, most of the more important bigger cap names report in the first two weeks and many of the smaller cap names will report later. Those companies that impact the indices will all report fairly quickly.
Trading
on earnings is not simply a matter of betting on a good or bad report. For
every quarter there are traders that are puzzled over a negative reaction to a
'good' report. It is never as simple as 'good' or 'bad' since expectations play
a major role in earnings reactions.
The
most important thing to know about earnings is that some of the best
opportunities occur after the earnings news and not before it. You can react to
earnings news and do quite well and still have lower risk.
Here
are some tips and tricks to keep in mind when trading earnings news.
- 1. You don't have an edge. Market players like to believe that they have some special insight into earnings news. They believe that they know more about earnings than the analysts that are in daily contact with management and already have great insight into sales and earnings trends.
The
perception that an individual investor has some superior knowledge about
earnings occurs because we are right so often just because of luck. Nearly half
the time a stock will have a positive response to earnings anyway. It is no
different than betting on a coin flip but with earnings there is an inclination
to think a winning bet is due to insight and not just luck.
- Keep in mind that many traders use options to play earnings. In these situations, the main focus is usually on volatility rather than a directional bet. If you believe a stock is going to make a big move on a report but expect a whipsaw reaction, then options may be the way to go. However, anticipating the level of volatility following earnings can be just as difficult as predicting a directional move.
2.
Charts do not do a good job of predicting earnings. Market players like to
believe that charts are predicting the future but when it comes to earnings
they usually do not do a good job. A great chart setup into a report is not a
reason to buy. Quite often a great looking chart is actually a negative
indicator because it reflects expectations that are too high.
- Some traders have a policy of not holding positions into earnings news because they view it as just a random bet. If you are a very short-term trader that can be particularly important because it is basically just a slot machine play if you are guessing on immediate moves. For longer term traders holding into earnings makes sense if you are playing an overall theme and, especially, if you are looking to build positions as volatility occurs.
3. Most
companies will beat analyst's expectations. It is not unusual for 80% of
companies to beat analyst numbers. Revenues are far less predictable and there
are quarters where more than half of companies will miss on the top line but
still beat on the bottom line.
Earnings
are mostly about beating expectations rather than published numbers. Many
companies purposely low-ball estimates to ensure that they will beat analysis
estimates. Action Alerts PLUS holding Apple (AAPL) was notorious for doing this
during the days of Steve Jobs.
- The real focus of the market is often referred to as the 'whisper number' but the number is imprecise and will be influenced by other metrics in the report. A big beat of the analyst number won't help a stock if the whisper number is significantly higher. And what makes it even harder is that no one knows for sure what the whisper number might be.
Often
companies will pre-announce earnings which makes the actual report
anticlimactic but it can be a good opportunity when the market has forgotten
that the numbers are already out there. Estimates may still be at the old
numbers even when there is a positive pre-announcement.
- 4. The best trading opportunities tend to develop after the earnings news. You do not need to be holding a stock into earnings to benefit. There is often a big move on earnings news but the market can be very slow in discounting good news. The reaction to earnings takes time to develop. Companies that have had a really significant report will not be recognized immediately in most cases. Analysts tend to up earnings estimates incrementally which means that good news often leads to further good news down the road.
Also,
on the other end of the spectrum, it is not at all uncommon for a 'sell the
news' reaction to seemingly good reports. For short sellers some of the best
opportunities came from 'fading' a strong reaction to a report that may have
buried negatives.
I often
find some of my best positions by following stocks that have had good reports
and then waiting while the chart develops. The best entry points may occur
weeks or months after the report. It is the good news that creates the
technical support that helps to reduce risk. I will sometimes establish
positions on the initial earnings news and then watch carefully for better
entry points to develop.
5.
Watch for themes to develop. Typically, there will be some sort of theme to
earnings reports. For example there are some quarters where earnings are solid
but revenues are soft. Or we might have a quarter where companies tend to
provide very weak or very strong guidance.
- In the current quarter I will be watching for themes about the impact of trade wars, corporate tax reform and the health of the economy in the second part of the year. Overall market direction will be largely determined by the themes that develop for earnings this quarter.
The
best thing about earnings season is that it creates new opportunities in many
stocks, but you have to think about earnings strategically and not just as a
bet on a beat or a miss. A month from now I plan on having at least 10 new
stocks on my watchlist because of good earnings news.
Get an
email alert each time I write an article for Real Money. Click the
"+Follow" next to my byline to this article.
0 Comments