Second quarter earnings season starts next week and will unwind over the following month. Generally, most of the more important bigger cap names report in the first two weeks and many of the smaller cap names will report later. Those companies that impact the indices will all report fairly quickly.
Trading on earnings is not simply a matter of betting on a good or bad report. For every quarter there are traders that are puzzled over a negative reaction to a 'good' report. It is never as simple as 'good' or 'bad' since expectations play a major role in earnings reactions.
The most important thing to know about earnings is that some of the best opportunities occur after the earnings news and not before it. You can react to earnings news and do quite well and still have lower risk.
Here are some tips and tricks to keep in mind when trading earnings news.
1. You don't have an edge. Market players like to believe that they have some special insight into earnings news. They believe that they know more about earnings than the analysts that are in daily contact with management and already have great insight into sales and earnings trends.
The perception that an individual investor has some superior knowledge about earnings occurs because we are right so often just because of luck. Nearly half the time a stock will have a positive response to earnings anyway. It is no different than betting on a coin flip but with earnings there is an inclination to think a winning bet is due to insight and not just luck.
Keep in mind that many traders use options to play earnings. In these situations, the main focus is usually on volatility rather than a directional bet. If you believe a stock is going to make a big move on a report but expect a whipsaw reaction, then options may be the way to go. However, anticipating the level of volatility following earnings can be just as difficult as predicting a directional move.
2. Charts do not do a good job of predicting earnings. Market players like to believe that charts are predicting the future but when it comes to earnings they usually do not do a good job. A great chart setup into a report is not a reason to buy. Quite often a great looking chart is actually a negative indicator because it reflects expectations that are too high.
Some traders have a policy of not holding positions into earnings news because they view it as just a random bet. If you are a very short-term trader that can be particularly important because it is basically just a slot machine play if you are guessing on immediate moves. For longer term traders holding into earnings makes sense if you are playing an overall theme and, especially, if you are looking to build positions as volatility occurs.
3. Most companies will beat analyst's expectations. It is not unusual for 80% of companies to beat analyst numbers. Revenues are far less predictable and there are quarters where more than half of companies will miss on the top line but still beat on the bottom line.
Earnings are mostly about beating expectations rather than published numbers. Many companies purposely low-ball estimates to ensure that they will beat analysis estimates. Action Alerts PLUS holding Apple (AAPL) was notorious for doing this during the days of Steve Jobs.
The real focus of the market is often referred to as the 'whisper number' but the number is imprecise and will be influenced by other metrics in the report. A big beat of the analyst number won't help a stock if the whisper number is significantly higher. And what makes it even harder is that no one knows for sure what the whisper number might be.
Often companies will pre-announce earnings which makes the actual report anticlimactic but it can be a good opportunity when the market has forgotten that the numbers are already out there. Estimates may still be at the old numbers even when there is a positive pre-announcement.
4. The best trading opportunities tend to develop after the earnings news. You do not need to be holding a stock into earnings to benefit. There is often a big move on earnings news but the market can be very slow in discounting good news. The reaction to earnings takes time to develop. Companies that have had a really significant report will not be recognized immediately in most cases. Analysts tend to up earnings estimates incrementally which means that good news often leads to further good news down the road.
Also, on the other end of the spectrum, it is not at all uncommon for a 'sell the news' reaction to seemingly good reports. For short sellers some of the best opportunities came from 'fading' a strong reaction to a report that may have buried negatives.
I often find some of my best positions by following stocks that have had good reports and then waiting while the chart develops. The best entry points may occur weeks or months after the report. It is the good news that creates the technical support that helps to reduce risk. I will sometimes establish positions on the initial earnings news and then watch carefully for better entry points to develop.
5. Watch for themes to develop. Typically, there will be some sort of theme to earnings reports. For example there are some quarters where earnings are solid but revenues are soft. Or we might have a quarter where companies tend to provide very weak or very strong guidance.
In the current quarter I will be watching for themes about the impact of trade wars, corporate tax reform and the health of the economy in the second part of the year. Overall market direction will be largely determined by the themes that develop for earnings this quarter.
The best thing about earnings season is that it creates new opportunities in many stocks, but you have to think about earnings strategically and not just as a bet on a beat or a miss. A month from now I plan on having at least 10 new stocks on my watchlist because of good earnings news.