Why I Avoid Earnings Trades

Four times a year, companies are required to release their quarterly earnings reports. This financial information includes their balance sheet, income statement, cash flow statement and other important details of their financial health. Usually, a conference call hosted by a top executive accompanies the release, discussing the company’s report. Investors are obviously interested in this information.

Some traders enjoy trading earnings, as I have in the past. At times, I have made a lot of money and I also lost, wondering how this could happen. Good earnings reports, the stock rises, I’m holding call options and yet I still lose?

Here’s why: a number of factors affect the price of an option, which is a reaction to the anticipated market reaction of the earnings. That’s not double speak; you read that correctly. Earnings per share, sales, profit margins product unit sales, plus these mentioned factors in relation to the analysts’ expectations of all those factors. Throw in the company’s future outlook, comments made by the executives in the reports and conference call comments all add to the mix. We are not done yet: add in how the stock performed leading up the earnings report release, sector behavior, volatility and fund managers rebalancing portfolios. It is like taking the many ingredients from my kitchen cupboards, throwing them all in together and expecting to make a great tasting cake when I have never baked one in my life… just not gonna happen.

Not that you cannot make money in earnings season; some folks do, I imagine. My experience with it was not positive on a consistent basis. I have seen stocks fall by 25% after a great earnings report. I have been burned by a stock gapping up huge on an earnings report and my call options all but vanished. How can this possibly happen? Just as an example, volatility tends to rise in anticipation of a favorable earnings report, then drops upon its release. Along with the drop goes the value of the calls. Missing the analysts’ expectations can painfully punish your options, as I found out when Nortel (many years ago) had an outstanding eps but missed the predictions by a quarter of a cent…  I lost thousands!  That was my last foray into earnings plays.

As I found one strategy after another just not cutting the cake, I stripped away all the slices that I did not like. It boiled down to one strategy that did work fairly consistently for me: take small gains on a stock that covers the entire spectrum of the top 500 stocks. Do it frequently in a controlled fashion, and live to talk about it the next day. Day trade SPY options… I will say it is a relatively simply concept but not always easy. Trading is not easy, but it seemed to work for me.

Now go enjoy a slice of cake.

Hugh Grossman

Head Trader, DayTradeSPY