Investors however can follow some basic principles and rules that may help them in navigating price volatility during earnings season.
Taking positional calls on individual stocks pre-earning announcement is a risky strategy, the outcome of such event is a binary one and if the result is contrary to the consensus then investors may get exposed to significant downside risk.
The stock price movement post-earnings declaration is also not predictable, there are numerous instances where stocks have corrected significantly post stellar earnings report, there could be multiple reasons for such unexpected price action, the most common being the prevailing market sentiment at that time.
Given the complexity, in predicting individual stock price movement pre and post earnings report it is only natural that investors are mighty confused as to what is the right strategy to tackle such event.
The most common and the safest strategy to follow is to wait and only enter a stock post-earnings once the dust has settled, the downside to this strategy is that investors carry the risk of missing out on a rally if the outcome is favourable however on the flip side the contrary outcome exposes one to significant price risk which may often be not palatable. Investors, however, can follow some basic principles and rules that may help them in navigating price volatility during earnings season.
Factors to keep in mind while analyzing the earnings of individual stocks:
Don't rest easy with consensus estimates:
While it’s wise to have an eye on analyst estimates, be wary of treating street estimates as the be-all and end-all measure for assessing stocks. These are simply estimates, a little more than educated guesses and should be taken as such.
Look beyond single quarter earnings:
Though there may be higher volatility in the stock prices in reaction to the quarterly earnings, it’s purely a short-term phenomenon and if the long term fundamental of a particular stock is intact investors should not worry and continue on with their long positions.
It is impossible to judge the fate of a company based on just one-quarter of performance and if you are a long term investor, these short term fluctuations should be ignored.
Rather than focusing on just one quarter’s number be mindful of average sales and EPS growth over the quarters for the last couple of years, it is also advisable to compare the numbers with a company’s peer group for identification of cyclical trends.
Have a second thought before exit:
While some investors sell right away if a company misses consensus earnings estimates, it's probably more prudent to look closely at why it missed the target.
Savvy investors don't rest easy with estimates; they look beyond consensus numbers. Just because a company misses estimates it doesn't mean it can't have great growth prospects, in the same vein, a company that exceeded expectations in one quarter is not guaranteed to continue on with the same momentum going forward.
Investors should also account for seasonality in the earnings report and therefore should always compare the numbers from the same quarter a year before to make any decisions regarding holding or liquidating their positions.
Strategy to play the earnings season:
For Investors: If you are a long-term investor, buying a stock right before earnings is akin to gambling on what those earnings would be. Since you don’t know how those earnings will pan out, a better strategy, therefore, is to wait and take any buying or selling decisions post-earnings. After the announcement, you should have more information and you would be better positioned to determine if you still want to own the stock.
The strategy, therefore, is simple; just avoid taking new positions in stock closer to its earning date. If you are a risk-averse investor and have reasons to believe that the earnings might be disappointing and if you are long in a particular stock it is always advisable to book profits and stay clear till the dust around the earnings results settle and if your prediction is correct you can always get back into the stock at a discount post-earnings.
An investor, who has a long term horizon, needn’t bother about the short-term volatility and should desist from getting lured into making a quick profit on earnings.
For Traders: For those who want to profit from the short-term price movement during the earning season, or for those who have decent risk appetite and stomach for volatility, earnings season is the perfect time to take calculated risks.
For e.g., if consensus earnings estimates indicate a positive outcome a savvy trader would initiate long positions at-least fifteen days prior to the earnings result day, stocks often react positively to positive consensus estimates and move higher right up to the event.
It is, however, advisable to book all profits and exit right before the earnings numbers are out because the outcome is a binary event which can go either way and if the results are contrary to consensus estimates the stock is bound to correct significantly.
Similarly, if the street is indicating that a particular stock is not going to have a decent quarter one can initiate a short position in the stock a couple of weeks prior to the earnings and exit right before the earnings day.
One can execute such strategy through stock derivatives either by selling futures contracts on the stock or buying near the money put options on the stock. In all cases however it should be noted that these positions should be mandatorily square up before the earnings report is out to minimize risk.
There is another slightly complicated strategy to play the earnings outcome on individual stocks but it is only recommended for seasoned traders who can analyze stomach and understand the risk-reward scenario for such trades. As discussed earlier earnings are binary events, therefore a stock can either react positively or negatively to an earnings report, a long straddle is a near-perfect tool to play such scenarios.
A long straddle involves buying a call option and a put option with the same strike price and the same expiration month. In order to use a long straddle to play an earnings announcement, you must first determine when earnings will be announced for a given stock.
You might also want to analyze the history of the stock itself to determine whether it is typically a volatile stock and if it has previously had large reactions to earnings announcements. The more volatile the stock is, the more prone it would be to react strongly to an earnings announcement.
Timing of when to enter a long straddle trade is especially important, some traders are comfortable initiating long straddles at-least a month prior to the earnings however such strategy involves higher cash outlay as there is significant time value associated with the options, an ideal time frame, therefore, is at least a week or ten days prior to the earnings.
Traders make profits on their long straddle position if the stock reacts very strongly in either direction based on the outcome of the earnings report. The scenario where traders lose money is if the stock remains range-bound post-earnings as in that case both call and put option would expire worthlessly.
The positives around a long option position are that the value at risk is always defined and a trader exactly knows how much he/she will lose if the strategy does not work out.
Earnings report on individual stocks is a binary event and therefore a stock can move either way based on the outcome of the earnings report. Investors with a long term horizon should only initiate long positions post earnings results, for investors who are already long in a particularly strong one-quarter of the good or bad result is not enough to make a decision on either staying long or exiting a long position.
Earnings reports in such cases should, therefore, be analyzed in greater details and a conclusion should only be reached after proper analysis.
For traders with risk appetite and stomach for volatility earnings season is perhaps the best time to take calculated risks, the trading strategy on earnings can be best executed through long option positions which can include buying a call or a put option or buying a straddle which involves getting long on both call and put options at the same strike price and the same expiration.
The Author is Director at Wealth Discovery/EZ Wealth.Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.Get access to India's fastest growing financial subscriptions service Moneycontrol Pro for as little as Rs 599 for first year. Use the code "GETPRO". Moneycontrol Pro offers you all the information you need for wealth creation including actionable investment ideas, independent research and insights & analysis For more information, check out the Moneycontrol website or mobile app.