The Earnings Trade
Due to a couple of strong, concurrent market narratives, the upcoming corporate earnings season is shaping up to be extremely dynamic.
Those narratives are the infamous trade war between the United States and China and the simmering tensions in the Middle East, which have combined to push up market volatility in recent weeks.
Earnings, in this context refers to the public release of financial results by publicly traded companies, which by rule must be done four times a year. Investors and traders follow earnings closely because this information provides valuable insight into a company’s operations.
After the release of earnings, investors and traders are theoretically better equipped to evaluate the underlying value of a company and to predict its prospects.
Earnings season is closely watched by both market participants and economists because the resulting tone and sentiment can have a significant impact on confidence in the economy and asset valuations.
While Q2 2019 earnings don’t get into full swing until the week of July 15, the early returns from companies that have already reported seem ominous. As most traders are aware, there isn’t a set day when every public company releases earnings. Instead, the “calendar year” for each company differs, which is why it’s often referred to as an “accounting year.”
That means “earnings season” actually encompasses the rolling release of quarterly reports over the span of several weeks. One day, 20 companies might report, and another day 50, and so on.
While the bulk of the earnings reports for Q2 2019 aren’t expected until mid-to-late July, 113 companies had already reported by the end of June. The tone of those reports indicated corporate profits may already be under pressure.
Of the 113 companies that reported, 87 reported negative earnings guidance, according to FactSet. Given the high percentage of negative reports (77%), equities traders are likely bracing themselves for more bad news.
While a variety of internal and external factors can compress earnings, a common theme cited in the 113 reports has been the ongoing trade war between the United States and China.
Given that trade war negotiations resumed after nearly a two-month hiatus, the current earnings season may be especially susceptible to enhanced volatility.
While traditional long and short investors certainly follow earnings releases closely to monitor how positions in their portfolios are affected, options traders frequently use volatility-based strategies to capitalize on upcoming or recently released announcements.
The latter trading approach is predicated on the notion that implied volatility tends to rise into earnings because of the uncertainty associated with the release of unknown (and pertinent) financial data. Because increased implied volatility translates to higher option prices, volatility sellers often get especially active during earnings season.
On the other end of the spectrum, long volatility positions can also be attractive if a trader believes that the implied volatility for a given earnings event has been priced “too cheap.” Traders often use data from past earnings to track the “typical” behavior of a given symbol on its earnings days.
Next, they compare that “past moves” data to the expected move for the upcoming earnings, which is implied by the value of the at-the-money (ATM) options in the expiration month that captures the event. If a trader does elect to deploy an earnings trade, it’s often in the form of a long or short straddle, which is essentially an expression of long or short volatility.
Traders looking to learn more about this approach to earnings may find a previous episode of
With financial markets already on edge because of the trade war, traders should find ample opportunities to deploy such positions in the coming weeks.
Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to support@luckboxmagazine.com.
