Navigating Earnings Season: A Three-Step Guide to Utilizing Earnings Reports

Steps for Utilizing Earnings Reports in Your Trading

Engaging in earnings season trading requires careful preparation, selection of target companies, in-depth market research, and the development of a robust trading strategy. Here are the three essential steps to make the most out of earnings reports:

1) Select Companies to Focus On

The initial step involves choosing which companies to monitor and trade during earnings season. Focus on a manageable number of companies, preferably those you are familiar with or have traded previously. Identifying the dates of their earnings releases is crucial. Paying attention to large bellwether stocks is also advisable, as their performance can significantly impact broader market sectors.

When selecting stocks, it’s important to understand that the relationship between earnings results and stock price movements is not always straightforward. While better-than-expected earnings are generally bullish, they don’t always result in immediate price gains, and vice versa. For example, Walmart’s strong earnings in Q3 2018 did not excite market participants, highlighting this unpredictable link.

A quarterly report offers more than just the past quarter’s results compared to expectations. Analysts are often more concerned with the company’s future outlook, as stock prices are forward-looking and incorporate future earnings projections. Therefore, a strong past performance may not guarantee positive stock movement if future outlooks are poor.

2) Conduct Thorough Research

Proper stock research involves comparing estimated earnings with analysts’ expectations for your chosen stocks. Additionally, examining historical earnings figures can help understand how the market has responded to previous releases.

While earnings season primarily focuses on individual stock performance, it can also reveal broader market trends. Common themes such as geopolitical tensions, regulatory uncertainties, or economic cyclicality often emerge, affecting entire sectors. For example, during the coronavirus outbreak, certain industries suffered while others, like shipping companies, saw increased demand.

Monitoring how headwinds impact various sectors is crucial. For instance, during Brexit, companies delayed capital expenditures due to uncertainty. Similarly, frequent mentions of trade-related issues during the US-China trade war highlighted broader sector vulnerabilities. Understanding these trends can help inform a macroeconomic trading strategy, providing valuable insights into market sentiment.

3) Formulate and Follow a Trading Strategy

Developing a trading strategy for earnings season should include entry and exit methodologies, profit targets, time allocation for trading, and a comprehensive risk management plan. Trading around earnings reports is challenging and carries significant risks, so any positions should be adequately hedged and include stop-loss orders.

Due to the infrequent and critical nature of earnings reports, they can disrupt ongoing price trends, causing traders to position for substantial price swings. Implied volatility often increases before earnings releases and drops sharply afterward, a phenomenon known as ‘IV Crush.’ This can create unique trading opportunities.

Trading Strategies for Earnings Season

Straddles: A straddle involves buying both call (buy) and put (sell) options with the same strike price and expiration date. This strategy allows traders to profit from significant price movements in either direction, provided the stock price deviates from the strike price by more than the total cost of the premiums. It’s useful when expecting high absolute volatility but uncertain about the direction of the move.

Short Straddles: Selling both call and put options with the same strike price and expiration date, a short straddle benefits from ‘IV crush’ when traders believe the stock price won’t move significantly. 

Strangles: Similar to straddles but with different strike prices for the call and put options, strangles are suitable if a trader expects the stock to move in one direction more likely than the other but still wants protection against an adverse move.

Key Takeaways for Trading Earnings Season

Navigating earnings season requires careful stock selection, thorough research, and intelligent risk management. With the right preparation and strategy, traders can capitalize on the unique opportunities presented by earnings reports. Effective trading during this period can maximize success and provide valuable insights for future earnings seasons.

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