Avert Earnings Disaster With These 5 Methods
With the tech-heavy Nasdaq 100 ETF (QQQ) up a whopping 40% year-to-date, tech stocks are off to one of their strongest starts ever. However, this quarter, there were several “land mines” to dodge post-earnings. For example, Super Micro Computer (SMCI), one of the top performers in 2023, dumped 23.39% in a single session after reporting earnings earlier in the week.
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Because earnings gap downs occur overnight, are binary events, and are largely unpredictable, unless you don’t play them entirely, they are impossible to avoid. However, with 5 simple steps, investors can limit risk during EPS season:
Traffic in Liquid Stocks
Though Super Micro Computer (SMCI) is reasonably liquid (market-cap of (~$15 billion), investors should allocate most of their capital to mega-cap stocks. For example, Apple (AAPL) recently announced lackluster earnings, but the stock fell less than 5%. Mega-cap companies like AAPL have the support of institutions. Most of your capital should be allocated to mega-cap, stable stock stocks.
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Avoid Chasing Extended Stocks
Even the strongest stocks revert to their 50-day moving averages. Upstart Holdings (UPST) is a recent example. UPST shares were extended a breathtaking 80% above their 50-day moving average. The result? Chasers got crushed. UPST plunged 50% over the past two weeks. The further the stock is stretched from the 50-day moving average, the more violent the pullback is likely to be. Remember, the equities market is one of the few mediums where people get more excited when something increases in price, don’t chase!
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Hold a Cushion
Another method of avoiding disaster is to pick and choose when you hold into an earnings report. You can create a rule such as “I must have a 10% cushion into EPS”. While such a rule does not guarantee you will avert disaster, you have essentially “earned the right to hold”. For example, if the stock gaps down 20%, and you have a 10% cushion into EPS, you’ve only taken a 10% hit to your initial equity. Most brokers give you the ability to find the implied options move. “Implied options move” refers to the anticipated price change of an underlying asset, as suggested by the movement in its associated options market.
Position Size Properly
Because earnings reactions occur in afterhours trading (and stop-losses won’t work), for common stock, the only true means of risk management is proper position sizing. Most amateur investors have position sizes that are far too heavy.For example, if you have a 50% position (% of assets in the position) and it gaps down 50%, you’ve just lost 25% of your account. Outside of position sizing, options are the only way to fully cap losses. For instance, if you have $3k worth of calls into a report, regardless of the earnings reaction, you cannot lose more than that amount. However, beware that one of the downsides of directional options trading is that you must have both your timing and direction correct.
Market Direction
The market direction is the equivalent of an underlying current in a body of water. To get the best performance, ensure that the market is in a bullish phase.While it depends on your time frame, an easy way to determine the market direction is to look at where the price is in relation to moving averages. I like to use a 50-day moving average for the mid-term trend and a 200-day moving average for the longer-term trend. Earlier today, I wrote a piece about why the market may be ready to head higher in the medium term.
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