Trend Trading Near Earnings Events

Last week I was asked how I trade around earnings. There are many ways traders choose to manage risk near earnings announcements. There are traders who exit entirely before the announcement, some reduce positions to account for the higher volatility event, and others who do absolutely nothing.

How you approach event risk is largely based on your timeframe. Because mine is of the multi-month/year variety it doesn't make a lot of sense to liquidate my holdings every three months. My back-testing did not take into account earnings related risk, it simply followed the rules dictated by the intermediate-term trend.

It's very important to understand your trading timeframe and how it relates to earnings risk. For a short-term trader, who holds for only days/weeks, it makes little sense to hold through an event like earnings. But for someone with a longer timeframe it makes just as little sense to sell each position every quarter.

The Key To Managing Risk is by Managing Your Position Size

Trading around earnings is not too much different than any other time, it still comes down to how do I manage risk in a volatile environment. The way I manage risk is to only carry a .50R position size per holding. Most stops are placed 5-10% from my entry price, so even if the stock declines 20% on its earnings, the loss incurred would still be just 1% of my total equity. That is an acceptable risk for my long-term survival in the market, which should be the goal of all market participants.

I believe where traders get into trouble is they begin to think too much about the possible rewards or potential losses that can come from an event like earnings. They let the event make them emotional and can then be prone to mistakes like selling too soon, holding too much of a particular stock, etc. 

Earnings create volatile moves, volatile stock prices make people emotional. Emotional investors do irrational things with their money. The best thing we can do is try to protect our portfolios from ourselves. If we have strong rules that have proven successful in the past, we can reduce our emotional reactions during volatile moments. We will be much more successful if we let the market dictate our allocations rather than positioning based on fear and greed. 

Rules I use for trading near earnings:

-Always maintain a reasonable position size. This is the most important concept. If you manage risk well, you will have little issue holding a winning stock through earnings.

-Re-balance position size if needed. Should the stock be trading sharply higher away from your stop level, sell some of the position to keep open risk at .50% of total portfolio equity. This assures that regardless of the event outcome your risk will be consistent. 

-Often I will place a "within 1-week" limit for entering a new position. If the company will report earnings the following week I will often pass on the entry until after the announcement. This has hurt and helped me in the past, but is a good way to limit earnings related risk.

-Look to add more shares of a stock that has reacted positively following its announcement. I always like to trade my winners more aggressively after a strong reaction to earnings.  

-I am weary of any stock that declines sharply after earnings. Post Earnings Drift tells us that a stock's movement after its announcement tends to continue for the near-term. Therefore a strong selloff tends to lead to lower prices rather than being a buying opportunity.