Earnings are the fundamental event in a company's quarter. After all, whether trading in the short term or investing over the long term, buying stock is buying ownership in the company - something that is implied but can be overlooked. At Tradespoon, a stock-picking service fueled by one of the most sophisticated statistical systems in the industry, earnings reports are one of the top fundamental indicators that we use to determine the timing and direction of recommended trades.
During earnings season - particularly this one with markets at or near record highs - investors and traders may be worried about getting into the market. Here are three reminders that should allay their fears:
- All the normal rules of trading apply. Traders should apply all of the usual rigor that accompanies their trading and investing criteria. Speculating on whether a company will "hit" or "miss" a number is gambling. Traders should always use stops and limits to predefine risk and reward ratios. And, traders should make sure they are comfortable with a reasonable degree of earnings outcomes - and not get spooked if the company slightly misses expectations.
- Options strategies shine during earnings. One risk for earnings is that prices gap between trading sessions, which impacts an entire equity position and could bypass stops. If the trader buys options or option spreads, the trades not only require less capital but also have pre-defined costs. The most that these trades could lose is the initial investment, while the upside may or may not be capped.
- More to it than "hitting" or "missing" expectations. Earnings reports are complex disclosures that are more than the initial headlines. Traders and investors should conduct their due diligence - read the reports and conference call transcripts - on any company they hold positions in and figure out if they need to adjust their position accordingly.
- Forget about companies with inconsistent earnings. There are multiple ways to "value" a company - revenues, earnings, cash flow, etc. But, one of the most important factors in a company's value is consistent earnings growth and performance relative to expectations. Without that, it is best to move along to another trade.
- Right before earnings might not best the best day to initiate positions. On earnings day, there are more than usual amount of variables that factor into a decision to enter a trade. And, with large traders exiting, hedging or otherwise adjusting positions, the risk/reward of entering a trade is unlikely to be favorable. It is just smarter to stay away.
Trading doesn't need to stop because it's earnings season. In fact, earnings season can provide some of the best opportunities to enter positions - as earnings data and market reactions provide key inputs behind the decision to enter a trade.