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Why Earnings Announcements Mean High Volatility and Risk

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June 21, 2016
Striking a match: Why earnings announcements can mean explosive volatility--and how you can manage risk
 

This may sound like the opening line from a bad TV special, but the fact is, trading results depends largely on choices. The strategy you use, the stocks you invest in, the amount of risk you take—these and countless other decisions you make can directly affect your profitability. And perhaps one of the most important choices traders have to make is whether to hold an investment over an earnings announcement.

Although a public company has the right to schedule an earnings announcement at any time, the vast majority of companies do so during what is called "earnings season," which generally begins one or two weeks after the last month of a quarter (December, March, June, and September). The unofficial start of earnings season begins when Dow component Alcoa (AA) releases earnings.

No Better Than a Coin Flip

The volatility that exists around earnings can create opportunities, but holding a stock into an earnings announcement—which almost always occurs outside of regular market hours—can pose an outsize risk.

That’s because there’s really no way to know which direction a stock will move post-announcement, so traders have no advantage going in. In addition, the movements in stocks immediately after an announcement are usually emotionally driven and often counterintuitive.

For instance, a company that delivers record earnings may actually see its stock sell off. Traders may have already bought the stock in anticipation of record earnings and now want to take profits. Some traders might think that earnings have peaked and the following quarter will disappoint in comparison. Or, despite great earnings, the actual number may pale in comparison to the "whisper number" many were expecting.

The point is, the reactions that come out of an earnings announcement are mostly subjective, and subjectivity is hard, if not impossible, to incorporate into a sound trading strategy. Furthermore, a stock can move by a tremendous amount because of this subjectivity, as shown in figure 1.

Volatility around earnings announcements

FIGURE 1: POTENTIAL RISKS AROUND EARNINGS ANNOUNCEMENTS.

LinkedIn (LNKD) is an example of a stock that experienced a dramatic move after an earnings announcement. The stock dropped by about 46.5% overnight from about $185 to $105 following its last earnings announcement. Data source: NASDAQ. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

 

Options to Manage the Uncertainty

Because of all this uncertainty, some traders avoid the risk by selling a stock before the company announces earnings. However, some traders prefer to hold positions going into earnings announcements and try to protect themselves against the volatility that can follow. This usually takes the form of an option position, which can reduce risk and potentially hedge against an unexpected and big move.

The most basic of these option/equity strategies is to buy a protective put on a stock. One drawback is that option premiums usually increase closer to an earnings announcement. The day after an announcement, option premiums typically decrease rapidly. The premium paid is the cost of managing risk.

Ultimately, to hold or not to hold through an earnings announcement is a decision that can't be ignored, and it’s one traders made based upon individual risk tolerance, time horizons, and personal money management philosophy.

Learn From a Leader in Options Education

Whether you’re an equity trader new to options trading or a seasoned veteran, TD Ameritrade can help you explore options trading strategies.

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