The ChoosaBroker Trading Academy

10.4. Earnings Trading

For better or for worse, quarterly earnings are the yardstick by which companies are judged. Shares prices tend to rally if actual earnings beat the consensus analysts’ estimate, and tank if they come in below par. While your long term investment decisions should not be affected by whether companies meet, miss or beat forecasts a couple of quarterly earnings, these events do provide profitable short term trading opportunities to those who know how to play around the numbers.

Earnings season is typically accompanied by greater than average volatility. While there are no set rules for trading corporate earnings, a few general guidelines, which can help you swim with the tide, are listed below:

Keys to Earnings Trading

  • The first thing to look for is when earnings of stocks on your watch list are scheduled for release. Earnings may be announced before the market opens, during trading hours, or after the close.
  • Be wary of treating analysts’ estimates as sacrosanct. While it is wise to watch estimates, don’t give them more respect than they deserve.
  • Stocks often fall on better than expected earnings and rise on weak numbers. The market can be fickle, but it is always right. Never try to question the market’s combined judgement. If a stock is falling, don’t go bottom fishing. The same holds true for shares that rise despite reporting weak earnings.
  • Companies reporting earnings during non-trading hours may see their underlying shares gap up or down in the subsequent session. Gaps can be tricky to trade. The thumb-rule is to never jump on to a gap. Wait for prices to settle and volatility to drop before forming a trading bias.
  • Avoid buying stocks that are about to announce their earnings. The inherent risk is just not worth taking. Once the earnings are out, pay close attention to how the market responds to stack the odds in your favour.
  • If you already hold a stock when earnings are reported, placing a stop loss to insure against a negative surprise is the prudent thing to do. Given the volatility, provide extra room to your earnings stop losses. A figure of around 10% is well established in trading circles.
  • Extra attention should be paid to stocks positions that have an unrealized gain and are about to post earnings. A trailing stop loss to lock in your profits in the event of market turning against you is highly advisable.

Long Term Investing and Earnings

Topping earnings estimates is a broad indicator of a company’s general well-being. If quarterly earnings routinely exceed expectations, the company is in all likelihood doing something right. Cisco Systems’ performance in the 1990s is an excellent example. For 43 straight quarters, the networking giant beat Wall Street’s earnings expectations, resulting in a multi-fold rally in its stock.

Contrarily, a company that consistently misses earnings estimates has something fundamentally wrong. Lucent Technologies in 2000-01, repeatedly fell short of estimates, in some cases by wide margins. It later turned out that Lucent was witnessing a huge build-up in inventories and had bloated cash outlays, which sent its shares plunging from $80 to 75 cents in just under two years.

While some investors prefer to sell shares right away if the company’s quarterly figures disappoint, taking a closer look at its books could reveal that the weakness was one-off. Savvy investors never rely solely on estimates. They always look beyond the consensus numbers. A good company doesn’t become bad because of one single sub-par quarter. If you have invested long term in a stock, and it reports a weak quarter, try to see if the long term growth story is intact. If the answer is yes, there is no reason why you should be selling the stock.

Final Notes

Corporate earnings are awfully difficult to forecast. Brokerage houses use projection models, guidance, and other fundamental tools in order to come up with an earnings per share (EPS) estimate. But in reality, analyst earnings estimates are, more often than not, nothing more than educated guesses. After all, companies themselves frequently fail to forecast their future earnings correctly. Why should Wall Street be any more well informed?

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