Tuesday, February 10, 2015

Dealing with earnings

The chart below shows a European stock in which I had a long position open, and this shows once again how earnings can work for you or against you.

Price broke out on 08 January, and thereafter a nice, quiet uptrend started to develop, to the point that profits equated to about +3R as of last night. This morning, the company’s latest earnings were released. Although the candle shows a drop throughout the day, in actual fact this was a gap down, while the trailing stop moved up today, so the stock opened up below the updated stop level. The end result was losing a significant chunk of those open profits.

When developing a methodology, traders need to consider how they will deal with earnings releases, which may be determined by your timeframe, entry/exit parameters and above all your appetite for risk. This should form part of your overall trading plan. 
For example, as my approach is towards the shorter-term end of the scale, I avoid opening new positions where I know earnings or trading updates are due to be released within the next week to ten days. People who trade longer-term methods will consider earnings simply to be noise on their charts.
 Once you are in a profitable trade, you have three options open to you:

  • To hold the full position through earnings;
  • To fully close the position ahead of earnings;
  • To reduce some of the risk, and take partial profits, while letting the remainder run.
I have seen traders use all three of those options. All I would say is that, whatever you decide, you should be consistent in your approach. 
Earnings can go for you or against you, and the potential for gaps through your stop levels can cause losses greater than you expected, or larger than your original risk on the trade. By avoiding opening positions just before earnings, at least you are giving the trade an opportunity to build up profits in the position before earnings are due to be reported. That way, you are building some additional risk protection. Yes, you may a chunk of the open profits, if not more, but hopefully the risk to your cash equity is reduced. 

This issue of potential gaps against you also makes the question of pyramiding on stock positions more problematic. Opening an additional tranche after the stock moves in your favour, only to be whacked down on a negative earnings report, could easily result in losses greater than your initial risk. This is why, as a position develops, my own choice is to look to reduce my risk on a position, not increase it, and therefore I do not pyramid my positions.

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