Article: How to trade during the earnings season?

This is a follow-up on the weekly comment posted last week regarding possible short trades based on the Effective Volume pattern.

We can see below that SXT and GPC lost 10%, ADTN lost 25% and POOL gained 5%

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Using puts with an investment that is equivalent to 10% of a normal short position, you can usually gain 300% on the position if the stock price moves 10% and 500% if the stock price moves 20%. This means a substantial gain even when referring to the original price of the stock. The risk being to lose 50% to 100% of your investment.

In the case of POOL, the price gain was only 2.5%. Hence the put lost 30% to 50% of its value.

This type of trade is not magic. It is based on the fact that some insiders have knowledge/deep analysis on the coming earnings and hence act before publication.

In the case of ADTN, earnings were OK, but the company was undergoing a review of its stocks of obsolete products. During the conference call, it was announced that next earnings would be hit by write offs. This had been known by many insiders and hence the large negative EV pattern before earnings.

This type of trades work best with mid/small sized stocks. It does not work for very large stocks such as AMZN, AAPL, NFLX, etc. because most ETF liquidity moves into these stocks and also because even the small players of the EV pattern include many large funds. Hence, the signal of large players may represent something else than advanced knowledge.

But even for small stocks, a large fund could be afraid before earnings and lighten its position. So there is always the risk of being wrong. However, statistically, since the Risk/Reward ration is 1/2 at least, if you have a 50% chance of success, this leads to substantial gains only during a brief earnings season.