How to deal with Earnings Announcement

Earnings Announcement is often an annoyance for traders. We were short when Advance Auto Parts Inc Stock opened at +20%; did we lose a lot of money?

Unexpected movements can always happen in trading, especially during events like the Earnings Announcement. Trading is risky, a speculation activity is not always profitable, we all know that; we can open a short position with a Stock, and lose 20% of our investment,  right the day after (we’d better call it “trading position” and not “investment“). This is exactly what happened to us trading Advance Auto Parts Inc Stock (Sympol AAP, S&P500) after the Earnings Announcemet. How should we handle these situations? How to avoid them? How can we build a trading strategy considering we have to deal with these situations?

 

What happened to us when we traded AAP

Let’s first have a look at one real trade we made with AAP, when we had to suffer a +20% opening after Earnings Announcements while we were SHORT (AAP EPS details here).

It is easy to show only good trades, so you can think we are the best, making only trades in profit… But this is not real; we have nothing to hide, a trading strategy is a whole system made of profits and losses. We care about the final result, which should be positive once we mix the entire profit with the entire loss. Here is our trading strategy record (our strategy is open and free to anyone, sent every day before the opening):

 

Earnings Announcement effect: Advance Auto Parts Inc in gap up

 

  • We were short from 87.89, using a 40% of the amount destinated to this trade.
  • We closed 10% at 85.63.
  • We closed 5% at 82. 63.
  • We closed 10% at 80.16.

You can notice we used fixed percentage to show the amount of capital we use to trade any Stock. The total we used was 40%, then we closed 10%, 5% and 10%, a total of 25%. We remained short in the market with 15%.

On November 14, AAP opened in gap up (because of the Earnings Announcement), and we closed the remaining SHORT position at the opening, at 94.88. Even if it turned out a bad trade, we have a profit! +244 USD if we used $40.000; ok, not a great profit, but still, we do not have losses suffering a gap up of +20% in a Stock we where short from 1 month ago. We did not suffer that much such a bad opening against our position, not because we are lucky, but because we manage to control these events. Let’s see the key points to work with Stocks and create an intelligent strategy.

 

Become aware of what you know and what you don’t

We see omniscience between traders, and it happens many times! “The Market will go there“, “this Stock cannot go lower“… I never believe in people talking like that; they are not aware that they do not know what they are talking about! They do not know that they cannot know what they are saying (what a mess of words :). If we are daily traders (I am not talking to long-term investors), we should not open new positions before the Earnings Announcement because we cannot know the effect of it (unless you really know it, but you should not). Considering the effect can be drammatic, we should avoid it. Trading before Earnings Announcement is definitly a way to bet on Black or Red: it’s gambling!

If we become aware of what we do not know, we understand trading, we develope a statistical approach and we get rid of hope. Hoping in a favourable Earnings Announcement is not a strategy, it is simply hope.

 

Reduce the exposition before the Earnings Announcement

If you want to trade and hope or you like gambling, believing you must be lucky to make profits, you should buy (or sell) right before the Earnings Announcement; in case you are lucky, you may end up with big profits immediately; if you are not, you have probably a bad loss right away. Instead, if you want to act as a professional trader, you just stay away from Stocks announcing Earnings. You do not have to be a scientist to understand it! The day before the AAP Earnings, I took safe profits, remaining SHORT with only a little part; I was not smart, I was wise, using common sense.

I have a precise strategy, which is not based on gambling situations, otherwise I would not use a PC with 8 monitors, but it was enough to go to Venice, where I could play to Casino in a magic city! But I am a trader. Hence, for what I know, taking advantage of untradable events, where Stocks can move in gaps of +/-20%, is not a professional approach, and not healthy for a serious strategy.

In case I am planning to open a new position with a Stock that has an imminent Earnings Announcement, I am not going to open any position at all. I rather wait a few days after it.

 

You cannot have just profits, but you can have profits bigger than losses

To do so, we simply have to create a strategy that has always a favorite risk/reward ratio. We should avoid trading Stocks where the risk is higher than the possible profit. Usually, the trader is the one who turns this ratio bad to him; it happens when traders do not let the position to follow the trend, usually because they lose patience, or they get nervous during choppy or sideways movements. It is not easy to be forward-looking, but it is the Key for big profits.

The real world is simple: the chance of buying a stock and make +20% in a few days is very low; but the odds of waiting weeks and have a +20% profits are much higher! Traders are not able to wait because they do not accept the reality or they overestimate themselves: you need patience to make big profit, and cut immediately the losses

 

Conclusion

Now, tell me: what does push a trader to have an important position (which is not largely in profit already) during the Earnings Announcement? That’s so obvious: the hope of making big profits in a short time, or the fear of losing an opportunity. There is no sense to take such a risk in any wise strategy. Hope and fear make us blind. Trading is not only a matter of numbers, but also a matter of consciousness, being aware of what is driving us when we trade. This is so important, so important, my friend.

 



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