Earnings season can be a great time for a trader to gain insight into their investments in stocks as well as capitalize on short-term volatility.

But in order to maximize this trading opportunity, there are several key considerations to consider before diving into them. Read on for our three steps to follow when using earnings reports to trade.

Preparing for reporting season involves choosing the companies to focus on and doing thorough market research before closing the deal.

1) Choose the companies to focus on

The first step is to select stocks to trade during the period. Traders are encouraged to look at a small number of companies, perhaps stocks they are familiar with or already trade, and inquire about the dates on which their earnings will be posted. It is worth researching the big top companies, whether you are trading them or not, as their results can impact broader industries.

When deciding to buy stocks, traders should understand that the relationship between the result of a profit and the subsequent price reaction is not always straightforward. While better-than-expected profits are generally bullish, they do not always result in immediate price increases, and vice versa. An example of this can be seen below: Walmart’s strong third-quarter 2018 earnings failed to interest market participants.

While the quarterly report is encouraging, it beats last quarter’s results compared to expectations. Indeed, analysts are often much more concerned about the future expectations of the firm, since price is a forecast indicator and future profits are calculated at current prices.

With that in mind, it makes more sense when investors shy away from stocks with good last quarter results but dire prospects for the future. A weaker outlook could seriously undermine current stock valuations, regardless of past performance, a fact all too often realized during earnings season.

2) Do your research

Proper stock research will require analyzing the estimated earnings for your chosen stocks and comparing them with analyst expectations. In addition, traders must follow historical numbers to understand how the market has reacted to publications in the past.

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While a reporting season is usually viewed in terms of what the results mean for an individual stock, the season as a whole can offer important insights as well.

Information is offered for specific companies, but general topics can ring true throughout. Headwinds such as coronavirus, geopolitical tensions, regulatory uncertainty or cyclicality can combine to create a wave of unease across the sector if mentioned often enough.

Traders should investigate how such headwinds affect one sector or stock relative to others. For example, while many industries were affected during the coronavirus outbreak, in March 2020, Greek tanker operator Top Ships Inc (TOPS) experienced a surge in demand for products in areas such as cleaning products and paper products, resulting in increased transportation demands. This, in turn, has led to an increase in trading volume and volatility.

The impact of headwinds has also been witnessed, for example with Brexit, as companies defer capital expenditures until post-Brexit order is in place and the business environment is stable. Likewise, frequent mentions of trade-related headwinds have undermined a range of sectors from semiconductors to basic consumer goods in the U.S. amid the U.S.-China trade war, as evidenced by the rise in references to “ tariffs ” in profit statements. and losses between China and the United States. companies from the S&P 500 list.

While these problems cannot doom stocks to negative returns on their own (as the TOPS example shows), their emergence across the market may hint at their prevalence and the wider downward pressure they could put on forecasts and estimates. Hence, traders should be on the lookout for common corporate complaints as this can help justify their broader macroeconomic strategy as anecdotal evidence accumulates to form a tangible threat to the broader index.

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3) Formulate a trading strategy and follow it

The formulation of a trading strategy for the reporting season should include entry and exit methodology, profit targets, time spent trading, and a risk management plan. Profit and loss statements are difficult and risky. For some, trading around an event may not fit their risk profile. Thus, any open position must be adequately hedged and include a stop. However, volatility can create unique circumstances in which there is scope for several specific strategies.

When developing a strategy for the reporting season, traders should be aware that quarterly earnings can seriously uproot the current price trend due to their relative scarcity and importance. This forces traders to enter positions for major price fluctuations, as evidenced by increased implied volatility.

Since it is extremely difficult for the average investor to correctly predict how a company will perform – let alone the potential impact on the price of its shares – the risk reward for taking a position immediately before the report can be skewed. If implied volatility is affecting the selected investment instrument, the impact on the position can be especially acute, since implied volatility remains high until the results are published, but usually drops rapidly thereafter, leading to the so-called “IV Crush”.

IV Crush is, as the name suggests, when the implied volatility of a stock drops significantly, usually because the uncertainty has passed. An abrupt change in implied volatility is often accompanied by perceived volatility, but not always.

The mismatch between implied and realized volatility allows for some unique trading strategies such as straddle and strangle, which seek to capitalize on the absolute volatility of options contracts, or short straddles and strangles, which seek to benefit from IV crash.

Straddles

Straddle involves the simultaneous purchase of a call (buy) and a put (sell) option with the same strike price (a fixed price at which the option holder can buy or sell) and with the same expiration date. In terms of profit, traders can hesitate before publishing and can profit from either a rise or fall in the share price if the share price deviates from the strike price by more than the total premium. This could potentially make the straddle a viable choice if traders think absolute volatility will be high but are unsure of the direction of the move.

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The chart below shows that Apple’s August 2019 earnings report prompted higher trading volumes and higher absolute volatility as indicated by the volume and average true range indicators, respectively, which is an example of a potentially favorable outcome for a straddle.

A short straddle involves selling call and put options with the same strike price and expiration date. This move is often appropriate for IV crashes where the trader believes the price will not move too much during the duration of the option contract.

Strangles

Strangles are like a staddle and can have a long and short path as well. But while straddles have the same strike price for call and put options, strangles have different strike prices. Strangulation can potentially be a viable choice if the trader believes the stock is more likely to move in one direction than the other after the earnings report, but still seeks protection if the position takes the opposite direction.

SEASON OF TRADING PROFITS: KEY FINDINGS

There may well be a period of uncertainty and extreme volatility during the season of profitable trading. This makes choosing the right stocks, careful scrutiny and intelligent risk management the keys to navigating the timeframe according to plan, as well as executing the right trading strategy. With all this in place, traders can maximize their chances of success and hopefully carry over some key knowledge into the next profit season.

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