The best trading opportunities occur when there are high levels of volatility. Few events create more volatility in individual stocks than earnings reports. Earnings reports can offer tremendous opportunities for traders, but they are often viewed as binary events and treated like betting on a coin flip.
According to Factset, 77% of stocks in the S&P 500 have beaten their earnings estimate over the past five years, and on average, earnings have exceeded estimates by about 8.7%. In other words, companies tend to manage expectations in a way that assures that they exceed analyst estimates. The market knows this, and that is why so many stocks end up selling off even though they exceed analyst estimates.
A straight earnings bet doesn't provide a trade with much of an edge. Traders love to believe they have some special insight into earnings that dozens of analysts with close relationships with management don't have. Not only do traders have to determine if a company is going to beat estimates, but they have to know what market expectations might be and consider the context of market conditions. It is tantamount to betting on a coin flip, and even if you are right initially, stocks have a tendency to reverse very quickly as earnings news is digested.
If you are a longer-term investor and are focused on fundamentals, there can be some benefit to buying in front of an earnings report. This is particularly true with smaller-cap names or stocks that do not have much institutional coverage. There are no clear expectations in these cases, and there can be an advantage for traders with a deep understanding of fundamentals.
Here's Where Aggressive Traders Have an Edge
It is very high risk to bet on an earnings report, but risk can be greatly reduced by trading the volatility that occurs after a report has been issued. Once the numbers are out, the risk of a surprise is gone, and then it becomes a matter of navigating the emotional reaction to the report. That is where the aggressive trader can find a real edge.
The first step in effectively trading earnings reports is to understand the overall market environment. Typically a theme will develop, and there will be a pattern of reaction. For example, we have had periods where there have been consistent misses on EPS while revenues have been exceeded, and there were positive responses to those reports.
There have been quarters where strong reports are consistently sold and other quarters where buyers aggressively buy pullbacks on earnings misses. Understanding the trading environment and watching to see if it shifts over time is extremely important.
Themes are often related to overall technical conditions. In a market that has been under pressure and where stocks are selling off in unison, it may not take a good report to bring in buyers. Simply not warning can be enough to drive a stock higher in some markets.
Make sure that you understand the report and the initial reaction. Quite often, a stock will gap up higher on good numbers but then drop sharply when guidance is discussed on the conference call. Guidance is the most important metric in earnings, and it is not always very clear at the time the report is first released.
The most common mistake that traders make when trading earnings reports is to be too aggressive at chasing the headline numbers. In some situations, stocks keep running straight up on good news, but it is far more common for early strength to be sold as short-term speculators take profits.
The best approach to earnings is to trade incrementally. If the report looks solid and technical conditions are good, take an initial position but then stay patient and wait for a second and third buy point to develop.
I often maintain a list of stocks that have had very good reports that I want to buy, but I may wait weeks or months for them to pull back and develop better technical patterns. Sometimes I will actively trade these favored names in extremely short time frames while I wait for the opportunity to build much larger positions.
Even if you aren't trading the initial reaction to earnings reports, you can develop a very good shopping list of stocks that have great results but are unable to attract much attention or are handicapped by market conditions.
Earnings reports allow traders to meld fundamental considerations with technical price action, which will lead to the best trading opportunities you will find.
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October 15, 2022 at 09:00PM
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The Secret to Trading Earnings Reports - RealMoney - RealMoney
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