First-quarter earnings season is kicking into full swing, and that's the time when stock market leadership fully reveals itself, as Wall Street reacts to the immediate results and mulls over future outlooks. Let's take a look at earnings season and how to trade stocks during that pivotal time.
Earnings reports cause many of the largest moves in stocks, and they require special care. Strong earnings can fuel top stocks to previously untouched levels — and above new buy points — while a less-than-impressive announcement can send shares tumbling.
Companies disclose their earnings reports four times a year, some weeks after the conclusion of each quarter. The quarterly reports offer investors an opportunity to examine how the company is performing at a detailed level. From there, analysts and professional fund managers use that information to project the company's future earnings and sales growth and create price targets for the company's stock price.
The stock market's reaction to an earnings release can often tell you more than the earnings themselves. If the results seem strong but the stock slides anyway, investors may be concerned about the sustainability of growth, rising costs or a myriad of other potential negatives.
Conversely, weaker-than-expected results with a positive stock reaction could mean that the company's future is bright despite the unexpected weakness.
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Check out IBD's Earnings Calendar for earnings previews, earnings due dates, Investing Action Plans, and stocks near buy zones ahead of earnings. Those stories carry stocks worth watching in the current market action.
How To Trade Stocks In Earnings Season
Investors know they should buy stocks on the breakout day, but what if earnings are soon after the breakout?
While there is no hard-and-fast rule to follow, there are a couple different strategies to help mitigate risk ahead of the earnings release.
One is to buy half the normal number of shares on the breakout. That way, if the stock reacts positively on earnings, you can complete the position with a lower average cost than if you had initiated the entire position post-earnings. Conversely, if the stock sells off, then you can sell the shares with a smaller loss than otherwise possible.
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Two, you can use IBD's earnings options strategy. In 2016, IBD introduced the options strategy to limit risk around earnings. The strategy provides a way to capitalize on the upside potential of a stock's move around earnings, while reducing the risk of a negative reaction. Weekly or monthly options can be used — so long as the cost for the option is right.
First, look for stocks at or near proper buy points. Most will be building bases. After that, look for a slightly out-of-the-money weekly or monthly call option. This means the strike price is just above the underlying stock price. Every strike price comes with a premium, or the cost of the option. Divide the premium by the stock price, and multiply by 100; this gives you the downside risk for the trade in percentage form. Look for trades with downside risk of 4% or less.
The strategy is detailed every week in the Earnings Preview column of the IBD Weekly print edition.
Breakaway Gaps Can Lead To Even Bigger Gains
When earnings season is going strong, investors should be closely watching top stocks as they report their financial results. A positive result could trigger a breakaway gap. That occurs when buying demand heavily outstrips supply at current levels, sparking a big rise in share price.
A perfect example of a breakaway gap occurred on Aug. 7, 2024, in shares of Taser-maker Axon Enterprise. Shares surged more than 18% in huge volume (Point 1) after the company's stronger-than-expected earnings and sales. The stock briefly traded at the 326.32 buy point, and closed out of the 5% buy area. The stock never looked back.
Over the next four months, Axon would advance as much as 114% before its next base formation.
Sometimes, a stock gaps up so strongly that it quickly moves past the 5% buy zone. In this case, use a five-minute intraday chart to see how well the stock holds gains after the gap-up. If gains hold and the stock shows strength and support by moving sideways, without giving up much ground, alternate entries can often be found.
This article was originally published on Oct. 22, 2021, and has been updated. Be sure to follow Scott Lehtonen on Twitter at @IBD_SLehtonen for more on growth stocks and the Dow Jones Industrial Average.
