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By: Costas Bocelli — July 12, 2012

3 Traps to Avoid During Earnings Season

‘Tis the season -- earnings season that is...

That quad-annual period is upon us once again, as companies begin to report their financial performance for the calendar second quarter which ended June 30. 

It unofficially kicked off with Alcoa (AA), the traditional quarterly starter, as they reported financial results and gave forecasted guidance after the close on Monday.  We’ll move into higher gear tomorrow when two of the largest money-center banks -- Wells Fargo (WFC) and JP Morgan Chase (JPM) -- report in the morning during pre-market trading.

It’s an important time for many investors and traders, as we get a transparent glimpse of how companies performed over the past three months and the opportunity to review the latest financial information that must be filed with the Securities Exchange Commission, known as the 10Q. 

It’s also a time when management tends to openly communicate with the investing public and industry analysts.  Most companies will not only talk about the prior quarter’s results, but will offer their opinions and outlook on current and future business conditions, commonly known as guidance or financial forecasting.  This type of information can be in the form of written statements or given orally during the company’s conference call which, by the way, is open to anyone who wishes to dial-in.

And it’s also a time when trading and investing can be very tricky, especially when trying to actively manage or take on a new position ahead of a company’s earnings release.  The very nature of the financial data and corporate guidance information that will be disseminated tends to increase the volatility and uncertainty in the stock’s price action around the event.

For many investors this can be a very unnerving time.  But some see it as yet another opportunity to analyze the fundamental health of their investments.  As for speculative traders, they tend to simply embrace all the uncertainty and increased volatility looking for huge speculative gains.

Today I’m going to share with you 3 traps you need to avoid as we begin to move through earnings season.  Once you become aware of these pitfalls, you’ll be that much more prepared for every upcoming earnings season.

Earnings Trap #1: Option Premiums are Expensive

If you trade options ahead of a company’s earnings release, you’ll find that the premiums tend to be relatively expensive.  And rightly so, since traders bid up the prices anticipating big moves from an uncertain event.

I’ve seen this common mistake made over and over.  An investor is looking for a bullish move ahead of earnings and buys a Call option.  After the earnings release the stock does indeed rise, but the investor loses money on the Call option!

How does that happen?  

The investor bought the wrong Option.  A common mistake is that many investors tend to buy out-of-the-money options as a means to get directional exposure.  What happens in many cases is that the premium paid for the option was far too expensive, and it underperforms the move in the stock price, even in cases where the stock moved significantly in the right direction.

The fix can be quite simple and can still offer you a directional bet ahead of earnings.  Take the bullish example.  Instead of buying an out-of-the-money Call, buy a Call option that is slightly in-the-money, which will be more expensive.  The difference is that, this time, we’re going to use the elevated premiums to our advantage by selling that richly expensive out-of-the-money Call against the one we just bought.

What we’ve essentially done is create a vertical Call spread.  The structure offers directional exposure while reducing much of the elevated premium risk.

This also works with bearish bets.  Simply buy a slightly in-the-money Put option while selling an out-of-the-money Put option against it.

Earnings Trap #2: The Financial Data May be Telling the Wrong Story

Have you seen this happen?  A company delivers an awful report and misses Wall Street estimates by a wide margin.  You start poring through all the financials and confirm the bad news.

But once you punch up the stock quote, you find that the stock is not getting pummeled.  Quite the contrary -- it’s up, and up big!

What’s going on?

The stock market is indeed a conundrum.  Stock prices move for all sorts of reasons, and may not necessarily be understood by many average investors.

One things that's for certain is that the market is a discounting mechanism.  And many times, what the freshly reported numbers say about the prior three months may be totally out of tune about the coming three months to six months.

While the financial data certainly can be a relevant piece of the puzzle, don’t make the mistake of making your investment decisions strictly from analyzing the financial data.

Alternatively, tend to focus on any comments management is making about guidance or future business conditions.  Also, nearly all earnings releases happen before the market opens or just after the market closes.  What I find useful to help me get the true picture of what is really going on is to watch the price action either in the pre-market or after the close, depending on the release time.  By watching the price action outside of regular trading hours, we can sometimes see clues to help us make better decisions.

Earnings Trap #3: Be Leery of Overextended Short Term Trends

Here is another common trap that catches many investors wrong footed, and it’s similar to the earnings report trap.

Picture this scenario:  A company reports earnings that meets or exceeds analyst estimates.  In the conference call, management raises forward looking revenue and profit estimates while portraying confidence in its business outlook.

However, when the stock opens for trade, it sells off.  What happened?

Most likely it was a “buy the rumor, sell the news” action.  It’s quite common, especially in very strong companies, where investor enthusiasm bids the stock so high heading into earnings that even a better than expected report usually results in profit taking or some type of pullback.

A potential example of this can be seen in Wal-Mart (WMT).  The company will report earnings in a few weeks, and the price action has indeed gotten far ahead of itself.

Everyone knows that WMT is a strong company and will likely report a solid quarter.  But will the numbers and guidance be far better than the expectation currently built into the stock price?  Perhaps, but odds are that this is setting up as a classic example of a “buy the rumor, sell the news” event.

 
Avoiding this trap is quite simple.  Sell your long position before the earnings announcement, or perhaps replace the stock position with the Bullish Call vertical spread we talked about earlier.  That action will maintain your bullish exposure while reducing substantial downside risk on a sell-off (or even worse, such as a gap down in case they surprise with a big fat miss!).

The bottom line is that earnings season can produce plenty of opportunities and offer investors lots of financial information, but it’s also a time of uncertainty and elevated volatility. 

Avoiding these simple traps, or at least raising your awareness to some of the common pitfalls, will no doubt make you a better investor and more confident during this quarterly event.

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