Stocks can sometimes trade with more volatility during earnings
Trading a stock right around its earnings announcement can mean more risk
Using options may help some qualified investors help narrow your earnings-related volatility risk
Even veteran traders sometimes feel shy jumping into a stock on one particular day each quarter: the day of the company’s earnings announcement. Stocks often leap and dive more quickly than usual in the lead-up to quarterly results and right after the news. That can mean more opportunity but also volatility risk that some might rather avoid.
Although nothing can guarantee you’ll be on the right side of a trade when a company unveils its earnings, there are smart approaches that might help you stay afloat amid related trading turbulence and perhaps even take advantage of the volatility. By learning how to prepare for the risk associated with quarterly reports, you won’t have to always find your towel and head to the shower just because it’s earnings announcement day.
Assuming you feel ready to take on the ups and downs of trading an earnings report, it’s important to consider a slow and methodical approach in regards to earnings annoucements. You might have to adjust your normal trading strategy, just as intermediate skiers might have to change his or her style to try a black diamond run studded with moguls.
“Traders should absolutely be more careful about trading earnings,” said Kevin Hincks, senior equity strategist in the Trader Group at TD Ameritrade. “Playing earnings events isn’t for the meek. You might have a nice, consistent trading strategy, but all that gets thrown out with earnings.”
One Way to Trade Earnings: Don’t
The first thing to consider before trading on earnings reports is whether you can stomach the associated risk. For many traders, and of course for the long-term investor, it can sometimes be better to stay away from the ebbs and flows of earnings season and wait until the dust settles. At the end of an earnings period, you can sort through the numbers, guidance, and conference call transcripts and then decide if you still want to own the stock.
The first phase of an earnings report trading strategy might involve watching the patterns over several earnings seasons before buying or selling a given stock. There’s nothing wrong with being patient.
Also, long-term investors may have a better chance of building wealth over the years by not trying to time the market or make trades based on short-term metrics like quarterly earnings. Research has shown that staying in the market and having a plan can help you avoid missing potential market gains.
On the other hand, being patient and waiting out earnings season isn’t necessarily the rule. Here are some thoughts on how to trade around earnings reports. Get ready to think about options.
Options Can Be Your Friend, and Sometimes Your Enemy
If you want to trade a stock on a company’s earnings announcement day, consider taking a close look at the options market. While it might help you narrow any volatility risk from a fast-moving underlying stock price, options are definitively not for everyone, and not all accounts qualify for options trading.
If you normally use options in your trading and are used to simply buying a put or call on a given stock, that might not be enough on earnings day.
Hincks said that, when trading around earnings reports, selling naked options might not be the best strategy, as such strategies have unlimited risk. “Instead, you might consider having a defined strategy that cuts off your losses if you’re wrong and still rewards you if you’re right.”
Developing that strategy, Hincks said, means getting familiar with a stock’s implied volatility (IV), which can easily be found on the thinkorswim® platform from TD Ameritrade. Navigate to the Trade tab and then type in the stock symbol. Next, select the Option Chain and scroll down to Today’s Options Statistics. The third item down the list is “Current IV Percentile” followed by a percentage (see figure 1). That’s the number to consider keeping a close eye on starting a few weeks out from earnings and right up until reporting day.
FIGURE 1: FINDING IMPLIED VOLATILITY. Take a look at the implied volatility for a given stock. Chart source: The thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
The left column of the “Today’s Options Statistics” page in figure 1 illustrates several key aspects that might help you better understand how implied volatility works. On the seventh line, you can see the current implied volatility of the options currently trading. The top two lines contain the 52-week high IV and the 52-week low IV. The third line from the top holds the current IV percentile. This shows (in percentage form) how the current IV compares with its historic highs and lows. Knowing if an IV is high or low historically for a given stock can sometimes help you choose the most efficient strategy for the current volatility levels. Implied volatilities tend to be elevated when earnings approach.
So what does current IV percentile tell you?
For instance, a 20% IV for a $30 stock means traders think the stock might either rise or fall $6 from its current level, meaning a potential price range of between $24 and $36. Knowing this range can help you determine where to buy puts or calls, depending on your thoughts about which way the stock might go.
IV plays a role in the value of an options contract. A higher IV means a higher options premium. This can be helpful to know in the immediate aftermath of earnings, when vanilla results can sometimes cause an IV collapse that removes value from the options contracts.
“You can be right in terms of a stock’s direction but wrong in terms of the IV, and that’s one of the biggest mistakes people make,” Hincks said. “It’s right church, wrong pew.”
Some traders, for instance, trade long puts on a stock, and then can’t understand why their trade lost money even though the stock went down following its earnings report. It’s often because the IV collapsed, removing IV premium from the options.
Another metric to consider getting familiar with around earnings time is the Market Maker Move (MMM), which you can also find on thinkorswim. The MMM only appears when the IV on the front options expiration rises above the IV of the second options expiration. It tells you how big a move traders have priced in around the upcoming earnings release. For example, going into Apple’s (AAPL) Q2 earnings in April, the MMM had priced in a 4% stock move, and AAPL actually rose 5% after reporting better-than-expected results and guidance.
“The MMM shows you there’s an event, and it’s measuring the one-day expected move in the underlying,” Hincks said. Knowing the MMM a day or two before earnings can help you calculate how to place options trades around the event.
It can also give you a sense of where to place stops if you buy or sell the underlying stock. For instance, if the MMM forecasts a 4% move, you might decide to place a stop at a level 4% under the current stock value to help cut your potential losses if the stock moves lower and you were expecting it to go higher.
Earlier, we mentioned that it helps to have a sense of how a stock moved around earnings historically. You can measure this on thinkorswim by selecting the Analyze tab and selecting Earnings. You’ll see how the stock performed versus implied volatility over the past eight earnings periods (see figure 2). Knowing all this can be helpful, but remember it’s no guarantee of how a stock might perform on its next earnings date. A surprisingly bullish or bearish outcome can sometimes cause all this to go out the window.
FIGURE 2: HISTORY CHECK. This page shows how a given stock performed versus implied volatility over the past eight earnings periods. The chart at the bottom shows how the company’s actual earnings per share compared with Wall Street’s estimates before earnings. Chart source: the thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Although understanding MMM and IV might help you place options trades around an earnings event, you also need to have a deep knowledge of the stock you’re trading to even get started trading on earnings day. That means digging into the fundamentals of a company and understanding what analysts expect to see and hear when the firm reports.
“There’s a three-headed monster with an earnings report: earnings per share (EPS), revenue or sales, and forward guidance,” Hincks said. “A company can have good revenues and EPS, but if the company gives bad forward guidance, the stock can go down, because stocks are forward-looking.”
A stock can go down immediately when a company reports based on data in its earnings release, so it’s important to consider staying right on top of the news and getting a quick look at the numbers. Try to get a sense ahead of time of the analysts’ average earnings and revenue estimates (the average EPS estimate can be found on thinkorswim), but also remember to do the footwork and find out if the company gave guidance in its last earnings report for the current quarter. Failure to meet that guidance, or projecting guidance for the coming quarter that falls short of Street estimates, can often cause the stock price to dive.
Even if you stay on top of all this, there’s still the company’s conference call to consider. If you’re trading the stock, try to listen to the call. Sometimes news or comments on the call can also have a quick impact on the stock price.
For example, in its Q1 earnings call in April 2018, Caterpillar’s (CAT) chief financial officer appeared to spook some Wall Street analysts by saying he believed that adjusted profit per share in that quarter would represent the “highwater mark” for the year. The stock fell quickly as many analysts and investors read the remark as bearish. If you’d already made your CAT trades and gone away before the conference call that quarter, you might have been taken by surprise to see the stock dropping dramatically. That’s why it sometimes pays to stay in the water until you’ve completed every lap on a company’s earnings day.
Learn more about the risks of trading earnings announcements by watching this short video.
The Risks of Trading Earnings Annoucements
Are options the right choice for you?
While options are definitely not for everyone, if you believe options trading fits with your overall investing strategy, TD Ameritrade can help you pursue your options trading strategies with powerful trading platforms, idea generation resources, and the support you need.