Trading Earnings Strategy (Backtest)

Last Updated on November 21, 2022 by Oddmund Groette

Earnings season can be a great time to get insight into different stocks, as well as take advantage of the short-term volatility that follows the release of earnings reports. Experienced traders look forward to the earnings season, as the increased volatility can present outsized opportunities for making good profits. But what is a good earnings trading strategy?

The earnings trading strategy refers to the trading methods short-term traders use to trade during the earnings season. This includes the strategy for market forecast, entry and exits, profit goals, time spent trading, and risk management methods. Trading earnings reports is difficult and risky and may not be suitable for all traders. Be sure it suits your risk profile before you think of the earnings season, and you must have a strategy for every possibility.

In this post, we take a look at trading earnings strategy and we’ll also include a backtest.

What are earnings

Earnings refer to a company’s after-tax net income in a given quarter or fiscal year. It is a company’s bottom line and describes the net profits after tax for the business period under review, which can be a quarter or full year. Earnings are used by investors, especially value investors, to determine a stock’s value, which is why it is perhaps the single most important and most closely studied figure in a company’s financial statements.

Earnings show a company’s profitability over the period and are often compared to analyst estimates, the value in the previous quarter or similar period over the previous year, and the earnings of competitors and industry peers. They show how the company has performed over the period and whether it has outperformed its own past performance, its peers, the industry average, and the current expectations.

At the end of each quarter when earnings are released, analysts study the figures and compare them with the various factors mentioned above. When earnings deviate from the expectations of the analysts, it can have a great impact on the stock’s price, at least in the short term. Generally, if the earnings beat the estimate, the stock price is likely to rise, and if it falls short of the estimate, the stock price might fall. For example, if the expectation is that a company’s earnings will be $2 per share and they come in at $2.50 per share, the price of the stock is likely to rise for beating the estimate. On the other hand, if the earnings come in at $1.50, the stock will likely fall.

However, it does not always work that way: other factors in the earnings report might influence how investors respond to the earnings. Nonetheless, it is safe to work with the idea that a company that consistently beats analysts’ earnings estimates is more favored by investors than a company that consistently misses earnings estimates.

The only exception is for growth companies that are using earnings to pursue growth — investors can buy into the growth idea. Examples include Amazon and Tesla in their early years. By and large, earnings are the key determinant of a stock’s price because they can be either invested in the business to increase its earnings in the future or used to reward stockholders with dividends. This is why they are used in many financial ratios, such as the P/E ratio. Given the big impact earning can have on a stock’s share price, the numbers are subject to potential manipulation, but the regulators monitor that.

What does trading earnings mean?

Trading earnings refers to trading during the earnings season, which is a period of time when a majority of public companies release earnings reports. It means taking a long or short position on a stock that is about to or has just released its earnings report to take advantage of the big price moves that usually follow such reports.

The earnings season usually lasts a few weeks each quarter, and there is often huge volatility in stocks during this period. Investor returns can be heavily influenced by how a company’s earnings report is received by the market. It is not unusual for the price of a stock to rise or decline significantly immediately after an earnings report. In fact, not much else impacts stocks like when a company reports earnings.

Given the potential for relatively big price swings, short-term stock traders don’t joke with the earnings season. This potential for a stock to move by a large amount in any direction in response to an earnings report can create active trading opportunities. This is why traders anticipate the reports and trade the stocks they monitor according to their individual trading strategies.

Some active traders start by making a forecast of the earnings and planning in that direction. The forecast may be essential since it will enable them to select only a few strategies, and there can be strategies for price moves to the upside, downside, and even both. They also consider how the momentum of the market as a whole might trump their evaluation of a particular stock. For example, a trader might believe that a stock’s earnings could be robust, but if the general market climate is still negative, they would consider how that would affect the stock’s price movement.

What is a trading earnings strategy?

The earnings trading strategy refers to the trading methods short-term traders use to trade during the earnings season. This includes the strategy for market forecast, entry and exits, profit goals, time spent trading, and risk management methods. Any active stock trader who wants to trade earnings reports must have a strategy for that.

The earnings season refers to the months when publicly traded companies release their quarterly reports — generally in January, April, July, and October. There is usually an increase in volatility that accompany a plethora of analyst predictions, expectations, and results that beat or miss those expert analyses. The volatility that follows earnings reports can create unique circumstances, ripe with opportunities for a few specific strategies.

One strategy is to directly buy or short-sell the stocks you are interested in. For example, you could buy the stock in advance if you think a company will report great earnings and anticipate the stock to increase after the announcement. On the other hand, you might short-sell the stock if you think a company will report weak earnings and anticipate the stock to fall after the announcement.

Another strategy is to use options: you can buy call or put options to replicate long or short positions, as the case may be. If you anticipate a positive price move when the earnings report is released, you can purchase call options before the earnings announcement. Likewise, you can purchase put options before the earnings announcement if the expectation is that there will be a negative price move after the earnings report.

Note that trading earnings reports is difficult and risky and may not be suitable for all traders. It is exceedingly difficult for the average investor to correctly predict how a company’s earnings report would be — let alone the eventual impact on its share price. As a result, the risk-reward of entering a position immediately before the earnings report is released can be skewed.

Before you think of trading during the earnings season, be sure it suits your risk profile. Given the risk, it is important to adequately hedge any position taken, and you may want to use a stop loss instead.

How to trade earnings

Trading earnings reports can be very difficult and frustrating if you don’t know what you are doing. It may not be suitable for inexperienced traders. If you must trade earnings, here are some steps to follow:

  1. Have a few stocks on your watchlist: You must choose the stocks to trade during the period, and you need to limit the number to only a few stocks you are familiar with or already trade. Find out the dates on which their earnings will be released. Note that the relationship between an earnings outcome and subsequent price reaction is not always straightforward. Generally, better-than-expected earnings produce a bullish reaction, but they do not always translate to immediate price gains and the opposite holds true for earnings misses as well. This is why you should also take note of large bellwether stocks in any industry your chosen stocks fall into, whether or not you are trading them, as their results can impact wider industries.
  2. Research your chosen stocks: This implies looking at estimated earnings for your chosen stock and how they compare with analysts’ expectations. You should also look at historical figures to get a feel for how the market has responded to releases in the past. Although earnings season is typically thought of in terms of what the results mean for individual stocks, the season as a whole can have some general theme. Watch out for the general theme and note how it can affect your chosen stocks.
  3. Create a strategy for trading them: Plan how you want to trade your chosen stocks. You can either trade the stocks directly by going long or short on the stocks or trade the stocks via options. When trading options, consider the strategies that fit your expectations of the earnings the best.
  4. Manage risks aggressively: Trading during the earnings season is generally very risky. The odds of accurately predicting the earnings result and how the market would react are quite low. If you must trade, ensure you manage risks promptly by hedging your position or using a stop loss.

Trading during earnings season

The earnings season is usually thought of in terms of what the results mean for a single stock, as each company releases its report. However, that is not all. There can be common themes that ring true throughout the season, ranging from geopolitical tension, trade wars, and regulatory uncertainty to cyclicality and sector rotation.

Sector rotation and other trading strategies may need to be reassessed as a result of any new information revealed in an earnings report. You should consider all those general market themes when trading during the earnings season.

Another thing to take note of is that the impact of earnings on a stock is not limited to the issuing company. In fact, similar or related companies’ earnings frequently have a spillover effect on other stocks in the sector.

In the materials sector, for example, the earnings report from Alcoa (AA) is particularly important because it is one of the largest companies in that sector, and the reactions to its report tend to affect other stocks in the sector. In addition, Alcoa’s earnings are significant because their release marks the unofficial start of earnings season.

What option strategy is best for earnings?

There are different options trading strategies traders use to trade earnings reports. The one you choose will depend on your expectation of the market. If you are expecting a positive price movement following the earnings report, you can buy call options before the report is released. Alternatively, if you anticipate a negative price move following the earnings report, you can buy put options prior to the announcement.

There are other neutral and semi-neutral options strategies you can use, such as straddles and strangles. Straddles involve simultaneously purchasing both the call (buy) and put (sell) options with the same strike price (the fixed price at which the option holder can buy or sell) and expiration date. You can straddle prior to the release. This way, you can profit from either a rise or fall in the stock price, as long as the stock price deviates from the strike price by an amount greater than the total cost of the premium. If you believe a stock’s volatility will be high following earnings release but are unsure of the direction of the move, a straddle could be a viable option.

Similar to straddles, strangles involve simultaneously purchasing both the call (buy) and put (sell) options but with different strike prices. You can straddle prior to the release if you believe a stock has more chance of moving in one direction than the other following an earnings report, but still seeks protection if the position takes a contrary swing.

Options trading involves more risk than buying and selling stock directly, and as such, only experienced, knowledgeable investors should consider using options to trade an earnings report. Before you think of trading options, you must fully understand the relationship between the strike price of an option and the price of the underlying asset, time decay, volatility, and options Greeks. That knowledge would guide you in considering when and which options to purchase before an earnings announcement.

How do you predict earnings?

It is difficult to predict earnings as an individual investor. Even the financial analysts that give estimates, follow the consensus estimates. Most analysts create financial models that project future revenues and costs in order to forecast earnings. Top-down factors that affect company growth, such as economic growth rates, currency movements, and other macroeconomic variables, are frequently taken into account by analysts.

However, there is a quick but often inaccurate way to use the stock chart to predict future earnings. This involves getting the average price-to-earnings of the stock over some quarters and then using the stock’s current price to calculate the earnings from the average P/E ratio. For example, let’s say we are in early January (anticipating the Q4 earnings), and you want to roughly estimate the earnings of a company. Assuming the Q1, Q2, and Q3 P/E ratios are 20, 30, and 40 respectively and the current stock price is $90, here’s what to do:

Average P/E ratio = (24 + 35 + 40)/3 = 33

Earnings = Current Price / Average P/E

= 90/33 = 2.73

What are some good sources for earnings calendar?

A company’s earnings report is a public document, and the company often displays it on its website, after filing it with the regulators. In the US, all publicly traded companies are legally required to file quarterly reports, annual reports, and 10-Q and 10-K reports with the Securities and Exchange Commission (SEC).

Some of the good sources for earnings reports include:

  • The Securities and Exchange Commission’s (SEC) website — SEC.gov: This is where you will get the most authoritative and complete resource for all earnings reports. Here, you can use their EDGAR system to search for any publicly traded company and read quarterly, annual, and 10-Q and 10-K reports.
  • Nasdaq online earnings calendar: This has a collection of coming earnings reports. You can search for a company based on a specific release date or by the ticker symbol to receive a brief overview of key information.
  • Brokers’ websites: Some brokers keep a calendar of companies’ earnings reports. You can search for the stock of interest and look for its earnings report.
  • The individual company’s website: Most companies have their earnings reports on their websites.

Other sources include financial news websites, such as Yahoo Finance, CNBC, and Bloomberg, as well as research groups, such as Morningstar.

How to make money on earnings reports

Many retail traders and investors believe that money can be made trading earnings report, but that is not always easy. While the high volatility that follows earnings release can be traded profitably, the risks are usually too much for an average trader.

If you want to make money on earnings report, choose the stocks you want to trade, study them, and create your strategy for trading them. Above all, start with paper trading before you put your money on the line.

Trading earnings strategy backtest

A trading earnings strategy backtest with trading rules, settings, and historical performance is coming shortly.

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