Earnings Season: A Comprehensive Guide to Trading
Introduction
Earnings season presents a lucrative opportunity for traders to gain valuable insights into their equity investments and leverage short-term volatility for financial advantage. However, successful trading during this period requires careful consideration and strategic planning. In this comprehensive guide, we will outline the three essential steps to follow when using earnings reports for trading.
Step 1: Choose Companies to Focus On
Selecting the right stocks to trade during earnings season is crucial. Traders are advised to focus on a small number of companies, preferably those they are familiar with or have prior experience trading. It is essential to identify the dates on which these chosen companies will release their earnings reports. Additionally, it is recommended to investigate large bellwether stocks, as their results can significantly impact entire industries, even if one is not directly trading them.
When deciding which stocks to consider, traders should understand that the relationship between earnings results and subsequent price reactions is not always straightforward. While better-than-expected earnings generally have a bullish impact, they do not always translate into immediate price gains. Conversely, weaker-than-expected earnings may not always lead to immediate price declines. It is important to note that analysts often prioritize future expectations of a firm, as price is a forward-looking metric where future earnings play a crucial role.
Considering these factors, it becomes reasonable for investors to shy away from stocks with strong past performance but abysmal future outlooks. A weaker outlook can significantly undermine a stock’s current valuation, irrespective of its historical performance. Traders should be cautious in making their stock selections and consider the broader macroeconomic and industry factors that may affect the future performance of a stock.
- Key considerations when choosing companies to focus on during earnings season:
Step 2: Do Your Research
Proper research is essential when trading during earnings season. Traders should analyze each chosen stock’s estimated earnings and compare them with analysts’ expectations. Historical figures should also be considered to gain insights into how the market has previously responded to earnings releases.
While earnings season is usually regarded in terms of what the results mean for individual stocks, it can also provide valuable takeaways on a broader scale. Information offered on a company-specific basis may exhibit common themes that reflect industry-wide factors. Headwinds like coronavirus, geopolitical tension, regulatory uncertainty, or cyclicality can have a combined impact on an industry if mentioned frequently enough.
Traders should investigate how these headwinds affect specific sectors or stocks in comparison to others. By examining the impact of such factors, traders can identify potential opportunities and risks within a particular sector or stock. For example, during the coronavirus outbreak, many industries experienced challenges, but Greece-based tanker vessel operator Top Ships Inc (TOPS) saw an increase in demand for cleaning supplies and paper products, resulting in higher trading volume and volatility.
Observing how headwinds affect the broader market can offer insights into their pervasiveness and the downward pressure they can exert on outlooks and valuations. Common complaints and concerns among corporations should be monitored, as they can inform traders’ broader macroeconomic strategies. The accumulation of anecdotal evidence can reveal tangible threats to the broader index.
- Key factors to consider during research:
Step 3: Formulate a Trading Strategy – and Follow It
Formulating a robust trading strategy is crucial for successful trading during earnings season. It should include a defined methodology for entry and exit points, profit goals, time allocation, and a risk management plan. Trading earnings reports can be challenging and risky, so it is important to assess risk tolerance and hedge positions accordingly.
During earnings season, quarterly reports can significantly disrupt ongoing price trends due to their relative infrequency and importance. Traders must anticipate significant price swings and position themselves accordingly, as evidenced by heightened implied volatility in the market.
Forecasting a company’s performance and its subsequent impact on share prices is exceptionally difficult. Therefore, entering a position immediately before an earnings report can carry skewed risk-reward ratios. Traders must be aware of the concept of “IV Crush,” where implied volatility remains high until results are released and then quickly collapses. This phenomenon can have a profound impact on investment vehicles affected by implied volatility.
To capitalize on unique circumstances created by volatility, traders can employ specific trading strategies. Two such strategies are straddles and strangles. Straddles involve simultaneously buying both call and put options with the same strike price and expiration date. This strategy allows traders to profit from a rise or fall in the stock’s price, as long as the price deviates from the strike price by an amount greater than the total cost of the premium.
Conversely, short straddles involve selling both call and put options with the same strike price and expiration date. This strategy is suitable during instances of “IV Crush” when traders anticipate limited price movement over the options contract period. Strangles, similar to straddles, involve buying or selling call and put options with different strike prices while seeking protection against contrary swings.
- Considerations when formulating a trading strategy during earnings season:
Key Takeaways for Trading Earnings Season
Trading during earnings season can be a period of uncertainty and extreme volatility. To navigate this period successfully, traders must prioritize selecting the right stocks, diligent background research, and intelligent risk management. Additionally, implementing the appropriate trading strategy can maximize the chances of success and equip traders with valuable knowledge for future earning seasons.
Further Information on Equities and Stock Trading
For those seeking more information about equities and stock trading, our stock market section provides comprehensive guidance on navigating this asset class. Topics covered include understanding the stock market, how to pick stocks, conducting stock research, risk management techniques, measuring volatility, and more. Expand your knowledge and enhance your trading skills to excel in the world of equities.