Earnings Report Trading Strategy (Backtest And Example)

Of course, companies release their earnings reports every quarter. If you are a short-term trader, you may have wondered whether to buy a stock before or after the release of its earnings report. What is the earnings report trading strategy? How to Trade Company Earnings Reports?

The earnings report trading strategy is a strategy that has its main premise to trading before or after an earnings report.

What is an earnings report? An earnings report is a financial document that every publicly traded company is required to release every quarter and year-end, which shows its expenses, earnings, and overall profit for the period under review.

Here, we take a look at the earnings report and look at backtested research and provide you with some potential trading ideas to develop on your own.

What is an earnings report?

An earnings report is a financial document that every publicly traded company is required to release every quarter and year-end, which shows its expenses, earnings, and overall profit for the period under review. Investors analyze the report to assess the company’s financial health so as to make informed investment decisions.

Earnings reports provide a periodic update of a company’s financial statements, including its income statement, cash flow statement, and balance sheet. In the US, public companies are mandated to file Form 10-K or 10-Q with the Securities and Exchange Commission (SEC) at the end of every quarter. In the forms, they report their performance for the period under review, which would be released to the public.

In general, an earnings report contains the following:

  • The period under review
  • The company’s details, including its tax identification and the location of the main business
  • A summary of the company’s earnings statement, cash flow statement, and balance sheet
  • Synopsis of the preceding period and the same period of the preceding year
  • An analysis of the company’s performance and operations by the management
  • The company’s present and future expectations and the results of the business operations
  • Qualitative and quantitative disclosures about market risk
  • The procedures and methods used to ensure that the financial information is accurate

Should you buy before or after an earnings report

Evidence suggests that it makes no difference whether you buy a stock before or after earnings are announced (on aggregate). While there may be increased volatility following the release of an earnings report, on average, a stock’s share price does not rise or decline more after an earnings announcement than on any other day. There is little correlation between share price changes and whether the report beats or misses the earnings estimates.

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Backtested trading strategies

However, this is based on the average of 30 stocks on the Dow 30 Index. Some stocks will jump after earnings and some will fall, but on average these changes cancel each other out. You need to backtest to see what happens with the stocks you are trading. However, to minimize risk, you need to have a diverse portfolio of stocks.

When to sell after an earnings report

The market is very erratic. You can’t just guess and expect a good result. The only way to know what works in the market is to test different ideas to find what works. So, to know when to sell after an earnings report, you have to make a specific testable strategy and backtest it to know if it has a statistical edge with positive expectancy. Read here for why trading requires constant trading ideas.

How do you trade based on earnings reports?

After earnings reports are released, some stocks will jump, while others will fall. While it may seem like it depends on whether the earnings beat the estimates, that is not always the case, as investors consider a lot of different factors and react differently.

There are many ways to trade, but the question is, which one of them gives you an edge in the market? You need to make your research, come up with ideas, and backtest them to find the strategy that gives you an edge.

Dow Jones earnings report trading strategy

Cassidy Cornblatt researched stock changes after earnings announcements using the most recent 4 quarterly earnings reports for all 30 stocks in the Dow Jones Industrial Average (DJIA) index and found that the average change was -0.2% with a standard deviation of 4.1%.

In comparison, the average daily change in the DJIA index for 30 random dates over the same period was -0.1% with a standard deviation of 1.0%.

Earnings report trading strategy
Earnings report trading strategy. Source: Cassidy Cornblatt

To our surprise, this means that there is little change in stock prices on average/aggregate after earnings are announced.

So, while the prices of individual stocks do appear to be more volatile after earnings, based on the standard deviation, it makes not much difference if one has a portfolio of all the stocks in the Dow 30 Index. The best way to achieve that is to trade the SPDR Dow Jones Industrial Average ETF (DIA), which tracks the performance of the index.

But volatility is one thing, a trading strategy can be based on other things than volatility (but we admit volatility is good for trading!)

Earnings report trading strategy (backtest)

We are not going to provide any backtest (with specific trading rules and settings) ourselves to find out whether or to find any earnings report strategy. It requires too much data and time.

Instead, we are going to look at other studies that might shed some light on such a strategy. For example, evidence points to increased tendencies for a powerful mean reversion around days of the earnings announcement than on other random days. We also come up with a couple of ideas that might be interesting for further research.

Let’s start with the earnings report and mean reversion:

Earnings report trading strategy backtest – mean reversion

A mean reversion strategy has worked well in the stock market for over three decades. To give you an idea about mean reversion, please check out these two free articles that contain many strategies:

The “traditional” mean reversion strategy of buying losers and selling winners has worked well around earnings dates, according to research. To be precise, a strategy where you buy past losers and sell past winners made an average gain of 1.45% over a 3-day period in a sample of stocks from 1996 to 2011. Compare this to only 0.22% when out of earnings season.

Why does this happen?

Most likely because of liquidity. Those who want to sell are willing to “dig Deeper” and those buying are willing to pay higher. This is why you over the long run are paid to provide liquidity.

One other reason for this happening is that market makers are reluctant to take inventory risk which increases during earnings season. Thus, market makers demand a higher risk premium to take on the risk and hence the prices go up (and down). When the earnings season is over, things “return to normal”.

When we day traded from 2001 until 2018 our strategies were more or less based on the same principles (to offer liquidity), albeit we didn’t trade any specific earnings strategy. We were never “riding the trend” or having any specific risk management. We spread our positions both long and short and traded many small positions – always on the bid and the ask. However, things have changed and increased competition has made many of the strategies obsolete, unfortunately.

Earnings report trading strategy backtest – the earnings date

Does a change in the earnings date matter?

According to the researchers at S&P Global it does. We quote from their report called The Dating Game
Decrypting the Signals in Earnings Report Dates
published in June 2019:

Many companies choose to report on a pre-determined cycle, for example, announcing second calendar-quarter results each year on the second Tuesday of July. The first part of this report focuses on companies that deviate from a historical reporting pattern. What does an advancement or delay of an earnings report date typically say about a company’s fundamentals, and should investors take notice of this event? The second part of this report examines a related topic – the market’s reaction to companies that postpone a previously scheduled (announced) earnings release date.

The idea behind the strategy is this: Prior academic literature documents that firms with negative earnings surprises tend to delay their earnings announcements, while those with good news tend to report early.

The main conclusion from the report is that those companies that advance their earnings date outperform those that delay the date by 3.59% annually. A long-short equity strategy generates 7% annually.

Earnings report trading strategy backtest

The table above shows that earnings date advancers outperform earnings date delayers by a pretty wide margin over many decades.

Earnings report trading strategy – further research and backtests

We have several times wanted to backtest a couple of trading ideas related to the earnings report, but we have never taken the time to do it. (Perhaps some other readers would like to do it?)

Our first backtest idea is this:

If a stock already is oversold at the time of the earnings report, how does the stock perform on the specific earnings day?

The logic and assumption are to sell the rumor and sell the fact. We assume that most negative sentiment is already discounted when the earnings are released. Is it a good idea to buy before the earnings day in the hope that the negative sentiment is already discounted?

Of course, the opposite scenario is also valid (the stock being overbought heading into earnings day).

Our second backtest idea is this:

The second idea is just a deviation from the same premise as above, but this time the stock continues the sell-off on the earnings day. What is the return in the coming days if we enter at the close the same day as earnings day?

More trading strategies

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Earnings report trading strategy – conclusion

Because the earnings day normally makes a stock move up and down a lot, you can most likely build some interesting trading ideas around these 4 seasons per year. Unfortunately, trading the earnings report strategy is a bit complicated because of the extra data you need in the form of dates. However, we are confident that there is tremendous potential for those willing to put in the amount of work required for the earnings report trading strategy.

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