How I Trade Earnings

 | Jul 13, 2013 | 12:00 PM EDT  | Comments
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Earnings season kicks off in earnest in the coming week, so this is a good time to reflect on the challenges and opportunities presented by trading based on earnings reports.

The main attraction is these reports serve as a catalyst for volatility. You are likely to see stocks jump around, which is always a positive for traders looking for action.

As a rule, I don't like to buy or short in front of earnings report; I don't see much of an edge. Betting on earnings is a two-step process. Not only do you have to predict whether the company will beat the published estimates, but you have to determine what the actual expectations may be. Just because a company exceeds analyst estimates doesn't guarantee a positive response. It is the "whisper number" that is the real key -- and even knowing what that is can be a challenge.

Betting on earnings is very attractive to many traders because they can get lucky and call it right a fair amount of the time. It is similar to playing a slot machine, where there are enough random payoffs to believe that you are skillful, rather than just lucky. If you are going to bet on earnings, keep in mind that you are rolling the dice and you really don't have much of an edge.

Playing options on earnings reports, on the other hand, is quite different from outright buys and sells. Often, the goal with options is to capture increased volatility rather than a directional move. But this is not my area of expertise, and I don't attempt this style of trading (for those interested, Real Money Pro's Tim Collins often shares his options strategies for earnings plays). I don't know how successful option players are, but they always seem to have a few big winners that keep them at it every quarter.

My style of trading during earnings season is to look for stocks to buy after the reports are issued. While there may be big gaps after the news hits, it usually takes time for the market to appreciate the numbers fully and figure out what they mean for longer-term earnings estimates. Often, the initial move after an earnings report is just the start of much larger trend over the intermediate term.

For me, the excitement of earnings season is it produces a new crop of trading candidates. You can always find new winners that are just starting to gain substantial earnings momentum, and they will be the stars over subsequent months. The adrenal rush of betting in front of a report isn't the same, but the long-term payoff can be substantial if you buy the right stocks on the news.

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