Three Simple Rules for Earnings Season

By TradeSmith Editorial Staff

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With the first week of this earnings season coming to an end, now is the time to prepare for some volatility. Each quarter, the first vital reports typically center around large financial institutions. So far, companies like JPMorgan Chase, Citigroup, Bank of America, and Goldman Sachs have shown positive earnings and revenue. And with the Federal Reserve set to taper bond and security buying while bond prices are rebounding, banks will look for positive momentum.

But what about the rest of the economy?

Right now, China’s stranglehold over the global supply chain is creating shockwaves around the globe. Consumer confidence is under pressure in the United States. Energy prices are surging. Inflation looks to remain red-hot in the months ahead.

And every company faces various microeconomic challenges heading into the holiday season.

Investors are facing a barrage of market noise this quarter. So, let’s approach the next two months with an action plan to protect your capital and set you up for success over the long term.

Step One: Think Long Term

As I noted yesterday, investors need to focus on the long term. For example, Amazon founder Jeff Bezos built an empire by focusing on specific trends in consumer behavior that would not change over 10 years. We should take a similar approach by focusing on the trends and sectors that will likely remain constant in the decade ahead.

Yes, many investors will speculate on next-generation technologies and different biotech companies that may — and I stress “may” — offer promise.

But we want to tap into companies with strong cash flow, dependable customer bases, and the ability to service a consumer need that will remain constant in the years ahead.

Any short-term downturn in cybersecurity, energy generation, senior care, and other “must-have” industries will provide investors with an opportunity to buy the dip. Remember, the market has a long-term, historical bias toward the upside.

We want to use any market overreactions to our advantage to buy stocks that we have wanted to own for years.

Step Two: Wait Until After Earnings to Trade Options

There is a great temptation to buy call and put options ahead of earnings reports. This is especially common if you are a first-time options trader who hears about the benefits of leverage.

Effectively, a call option can return a very large gain if there is a significant upward price movement after a company reports earnings. The same goes for a put option, should the company’s earnings report produce results well below expectations.

But that is a speculative and dangerous game to play for two reasons. First, without some strong indicators one way or another, it’s a risky venture to try to guess whether a company will or will not beat earnings, alter their forward guidance, or engage in an accounting practice that might lift the stock.

For example, the earnings report might fall well below expectations. A put buyer might smile, thinking the stock will tank. But the company might then announce a stock buyback during the call, or the executives may announce plans to start a new business division. This can send a stock doomed for a loss back into the hands of a bullish crowd.

It’s easy to lose 100% of the value of your option in a day. It’s also easy to find yourself stuck in a trade because of low liquidity or wide bid-ask spreads.

The second element to consider is the volatility around earnings. Each stock has implied volatility ahead of earnings, reflected by the price of call and put options. Around earnings, volatility is typically higher because speculators are wagering on the direction of the stock after the report. This increase in volatility increases the options contract’s value, which in turn can cost you more money to speculate on the post-earnings move (or “drift”).

Following earnings, however, the implied volatility crashes. Thus, in the days after the earnings report, you might see volatility drop from sky-high levels and make options contracts justifiably affordable.

At this point, investors should consider using options to enter positions for the long term with the use of in-the-money calls or LEAP (long-term equity anticipation) options.

Step Three: Remove Emotion from the Scenario

The third step here is to remove emotion from your long-term portfolio. This could be a tricky earnings season, with many concerns about supply chain delays, inflation, energy costs, and more.

However, we have been here before as investors. We’ve witnessed remarkable credit crises, we’ve seen an unprecedented pandemic, we’ve navigated North Korean missile launches, and we’ve handled debt ceilings.

The financial media isn’t here to help you manage your money. The financial media is designed to make you feel like you’re falling down a flight of stairs without any rails to grab. You must take control of the situation even when the headlines make it feel like the world is collapsing around you. Fear sells headlines, and these headlines cause us to overreact.  

The point is that we’re still standing. One should not allow short-term fear to overtake long-term upside. We have seen people sell their stocks out of fear and then buy shares back at higher prices.

I don’t want you to feel the frustration I felt a long time ago with panic-selling and then regretting those sales, months down the road. That’s where our tools can help. TradeSmith Finance provides custom trailing stops for every publicly traded company based on its historical volatility.

By using trailing stops and other tools to protect your capital and gains, you can overcome your emotions being triggered by market earnings.

I’ll be back on Monday with more insight on the earnings season. I’m also taking questions in our subscriber mailbag. To start with one request, I’ll be digging into the health of telecom giants AT&T and Verizon early next week.