How to trade company earnings

This post was originally published on 26 December, 2023.

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Earnings season is a trader’s paradise, providing opportunities to profit from significant stock price movements based on company earnings reports. But it can also be a minefield if you don’t understand how to trade earnings properly. 

In this article, we will go through:

• What are earnings reports?
• When is earnings season?
• Crafting an earnings trading strategy

What are earnings reports?

Public companies release quarterly earnings reports detailing their financial performance over the past quarter. These reports include key metrics like:

1. EPS (earnings per share) – The total net income or profit earned per share of stock outstanding. This is a key measure of overall profitability.
2. ‍Revenue – Total sales/revenue generated by the company during the period. This shows the overall size and growth of the business.
3. ‍Operating income – Profit left over after deducting operating expenses, taxes, interest, etc. This is the bottom line earnings number.
4. ‍Gross margin – This is gross profit as a percentage of total revenue.
5. ‍EBITDA – Earning before interest, taxes, depreciation, and amortisation. This helps compare profit across companies.
6. ‍Forward guidance – Management’s forecasts for future quarters or fiscal years. This provides an outlook on growth expectations.
7. ‍Cash flow – Net change in cash generated/spent during the period, which is an important metric for liquidity.
8. ‍Balance sheet data – This is a snapshot of the company assets, liabilities, and shareholder equity which shows financial strength.
9. ‍Segment revenue – This is the revenue breakdown across business units/product lines. This reveals growth areas of the company.

EPS and revenue numbers are compared to analyst estimates, which are typically averages of projections made by market experts. If a company’s actual EPS or revenue exceeds the analyst estimates, it is seen as a positive earnings surprise. If the numbers fall below consensus estimates, it is an earnings miss.

Earnings reports also often include forward guidance from management about expectations for the next quarter or full year. Conference calls with executives discussing results may also influence stock prices based on the tone and outlook provided. Overall, earnings reports give crucial insights into the financial health and trajectory of a business, and major deviations from expectations frequently cause sharp revaluations in stock prices.

When is earnings season?

The earnings season generally occurs in the weeks following the end of each calendar quarter, which are the months of January, April, July, and October. Different markets and regions may have slightly different schedules for earnings season depending on their fiscal years. It's a good idea to check with financial news sources or the investor relations sections of company websites to find exact release dates.

Earnings announcements are scheduled outside regular trading hours to ensure broad dissemination without disrupting the trading day. This entails releasing reports either before the market opens or after it closes. This approach provides traders ample opportunity to absorb the information and decide on their subsequent actions.

Crafting an earnings trading strategy

Here are some tips for developing an effective approach to trading earnings announcements.

1. ‍Know key dates – Compile a watchlist ahead of time so you know which companies will be reporting earnings. Pay attention to when they will be announcing results so you are prepared to trade the initial volatility right after numbers are released.
2. ‍Use stops – Volatility and gaps can swing prices quickly after an earnings print. You can use stop loss to limit potential downside risk on any trades. However, bear in mind that tight stops may get triggered very quickly, so the optimal position sizing should be used instead.
3. ‍Evaluate analyst estimates – Examine the consensus EPS and revenue estimates closely heading into the announcement. Compare these estimates to the results of previous quarters to gauge how challenging it will be for the company to deliver another earnings beat. The higher the bar, the bigger the reaction could be if expectations are exceeded.
4. ‍Consider options prices – Options markets are typically forward-looking, so checking call/put prices for an expiry date immediately after earnings announcements may reveal some information about how the market is positioned. You can also use this information to trade the implied volatility if you think the reaction will be muted by selling “volatility”. Or you can buy the tail risk to benefit from outsized intraday volatility and limit downside risk.
5. ‍Plan entries and exits – Use technical analysis to identify key support and resistance levels to help time your entries and exits. Look at moving averages, past trading ranges, and volume patterns to pinpoint ideal buy and sell points.
6. ‍Use stops – Volatility and gaps can swing prices quickly after an earnings print. You can use stop loss to limit potential downside risk on any trades. However, bear in mind that tight stops may get triggered very quickly so the optimal position sizing should be used instead.
7. ‍Review your performance – Be sure to track your earnings trades to assess what worked and didn’t work. And make adjustments to improve over time.

While trading earnings announcements can be immensely profitable thanks to the pops in volatility, it's essential to note that these increased price swings also amplify the potential for losses. Doing your homework and planning ahead will help you make informed decisions during the earnings seasons.

You can open a demo or real trading account with Deriv and take advantage of the price movements happening during this exciting season.