Earnings Season. What does it mean, and how does it influence stock performance?

Every quarter, US companies are required to present a financial report to the SEC and subsequently the public, showing the financial performance of the company for a specific time period.

An earnings release date is scheduled for a specific date, with the company then issuing an earnings estimate for the upcoming time period (typically a quarter or year). This estimate is used by analysts, industry professionals, and the general public, to then evaluate an expected performance.

When the company releases their earnings data, they will meet, exceed or miss those expectations. This can cause the stock price to rise or fall quite dramatically. In fact, quite often we see stock prices gap excessive amounts when investors are shocked (positively or negatively) on the report.

Certain types of stocks (industry) have varying levels of volatility that influence investor reactions to earnings results. For example;

  • Blue chip stocks or large conglomerates (Berkshire Hathaway; Johnson & Johnson; General Electric), are typically slower moving stocks (less volatile in price movement), and do not react excessively in stock price
  • Biotechnology stocks (in the medicinal industry producing biological drugs), or even Technology stocks can react quite harshly when earnings results differ from expectations – both good and bad.

During positive economic periods, also referred to as a Bull market, we normally experience positive reactions to earnings results. Even if the company reports as expected, or slightly misses, the share price might only react marginally and eventually resumes a broader growth trend.

Weak or negative economic environments will typically find companies missing their earnings reports. Or, revising their expectations down as revenue (sales) results decline.

As you can see, the broader economic environment can influence expectations and final results. So you need to be aware of where the broader economic/fundamental cycle is.

How do you manage/react to Earnings Reports?

Investors, those who purchase stock for long-term positions, typically need to ride through any stock market reaction. As a long-term investor, you are looking for capital growth and/or dividend returns. So as long as the earnings report, and the projected expectations continue to show growth potential, there should be no reason to adjust your position.

Traders on the other hand, are typically looking for short-term directional movements from stocks. Either up or down. But the uncertainty surrounding whether the company will meet, exceed or miss earnings expectations, means it is basically a wild punt as to how the markets will react to the report.

Sure, during steady economic environments there is more certainty. But I can quote many reports in the past where earnings have exceeded expectations but the stock price has still dropped. Apple comes to mind, several times over the last decade.

My recommendation to short-term stock traders is to not hold a position as it heads into its earnings reporting date. Make this part of your trading management plan, and avoid any high risk/uncertainty.

If you are really keen to try and trade those earnings fluctuations, the best methodology I use is with Options, trading what is referred to as the “Volatility Crush”.

The Voodoo that is October!

For the last 15 years, October has always been the earnings period where I’m sitting on a knifes edge.

My study and analysis of historic stock market crashes, and what I have experienced in 20 years as a professional analyst/trader, is that October is a common period for stock market crashes.

Performance economically/fundamentally through the middle of the year can lead to poor performance for company’s, who then reporting in October, result in missed expectations. Subsequently resulting in fear driven (panic) selling. The momentum shift leads investors to drive the markets down, and we get the “October effect”.

So, I am always cautious heading into the October earnings season.

2018 seems to have all the same warning signs that I have seen before. But just because I am concerned, does not mean I am running for the hills. Quite the opposite. I am cautiously evaluating as the weeks unfold.

Your management of positions through earnings season should be one that you are prepared for before the event. Your investment plan should include how you are going to manage your portfolio, including what parameters you need to see to maintain the position, what degree of change in earnings expectations from the company will define you exiting the position, and what your action plan is depending on the reaction of investors to the report.

Using the “Hope and Pray” method is not a strategy. You shouldn’t leave anything up to chance.

While there is uncertainty in what a stock price will do in the future, you have control over your decision-making and what your course of actions should be. Being blindsided by the markets is really just an excuse for lack of analysis and insight. And even then, you should have an action plan prepared if something extraordinary occurs (as they do).

If you have any questions about earnings and stock price reactions, feel free to send me a message in the contact form below.

Bonus: Do you want some real insight into the reaction of stock prices?

Most stock investors/traders spend their time analysing the fundamentals of the company and the technicals (charts) to define whether it is overbought/oversold; at great value or has potential for growth.

As a professional derivatives analyst, I’m looking a little deeper than that. Option prices have a whole other level of theory, which makes it a little hard for the average investor. Especially if they’re not willing to put the time into learning and understanding this exceptionally insightful market.

Options provide us some great insight into stock price movements, and how the broader market is reacting.

A very simple method stock investors can use is Option Implied Volatility.

As the attached image/chart shows, you can include the option IV on the stock chart. It is a forward looking indication that gauges the sentiment about the volatility of the stock.

IV is a mathematical calculation, which when it was developed, earned its developers a Nobel prize in economics. These guys are certainly smarter than I am, and as a method that has been used for more than 40 years, there is some merit behind the effectiveness of understanding option analysis.

What option IV is showing us on the stock chart is uncertainty or fear amongst investors. When IV rises, there is greater uncertainty to the future price movement of the stock. When it falls, there is more certainty.

Upcoming earnings announcements are a great example. As there is increased uncertainty as to how the share price might react on the earnings announcement, IV increases (as depicted in the attached chart). Once the announcement is made, investors have certainty of results. So IV drops dramatically.

What Option IV won’t show you is a prediction of where the share price will shift. There is no crystal ball that does that. How the share price reacts is dependant on the result and the built up expectation of investors. You can form an opinion on what you expect the share price to do, but you must always be aware that it is an “educated guess”. As I state, no-one can predict the markets consistently and indefinitely.

As an options trader, you can implement strategies that benefit from this decline (or crush) in option IV. Strategies such as Iron Condors, Butterfly’s, or basically any selling strategy. These are referred to as non-directional strategies, which means they do not need the share price to rise or fall. They profit from the drop in IV. And because this is a common occurrence during earnings reporting season, they can be very effective strategies.

Be aware, however, that these options strategies are advanced. Beginners can simply implement them, but that does not guarantee success (there are no guarantees in the markets). Portfolio money management is exceptionally critical with these strategies, and you need to be aware of increased brokerage costs due to the multiple option legs that are implemented.

As with all strategies, you should practice and define a trading approach that meets your needs.

If you would like to know more about these types of strategies, feel free to contact me below.