The influence of corporate earnings on trading

Earnings reports reveal how much money public companies made and spent over a quarter. They lay out how much money's coming in from sales (that's the revenue) and where this income is going (cost).

These quarterly reports allow investors to see how public companies are performing to decide whether to buy, sell or hold on to that company’s stock.

Positive reports get investors excited about the prospects of a share’s future price. But when companies miss expectations or deliver bad news, investor confidence takes a hit and stock prices sink. So, these reports carry real weight in the markets. They help investors decide whether it's time to buy, sell, or hold on to shares. This way, earnings news can sway market volatility.

How can corporate earnings reports impact trading?

Affecting market indices

Company reports affect market indices because those indices are made up of publicly traded stocks. Index values go up or down based on stock price movements tied to company earnings news. The market reacting to a few key company reports is enough to tilt even major indices like the S&P 500.

Central bank decisions

Central banks try to help the economy by setting important rules, like deciding on interest rates or how much money circulates in the market. When lots of big companies show great results, it is a signal that the economy is doing well. This could influence central bank decisions on interest rates and monetary policy. On the other hand, if earnings are down, central banks might think about adopting more accommodating measures.

Volatility in stock prices

Unexpectedly positive or negative earnings reports have the potential to induce heightened volatility in the stock's value. Traders are typically very quick to react to new information, which can easily trigger fluctuations in stock prices when a flurry of buying and selling gets underway.

Surge in trading volume

Higher trading activity is a double-edged sword. On one hand, more volume provides more liquidity - it becomes easier to enter and exit trades when there are more active buyers and sellers in the market. There's ample interest on both sides allowing stock or assets to change hands easily.

However, increased volume can also introduce greater unpredictability and price swings, sometimes referred to as herd mentality. More traders making quick plays on market trends or hype stocks can whip prices around as sentiment shifts.

Influencing foreign investment

Positive reports can bring in more foreign investment to a country's market, which means more demand for its assets. Negative reports could make foreign investors less interested in that market and reduce their involvement.

Shaping investor sentiment

An earnings report has the power to sway how investors feel about a company or the market in general. Positive earnings can increase optimism, while disappointing earnings can make investors more cautious and risk averse.

How an earnings report impacts the price of a stock depends greatly on what investors expected. If earnings exceed estimates, the price tends to go up. If earnings disappoint, the price often drops.

Meeting expectations is key. Even good news might sink the stock if investors hoped for better news. And a stock could jump if bad news wasn’t as bad as predicted.

For instance: if the market anticipates a 30% surge in earnings, a 15% rise may not be viewed favourably, resulting in a decline in the share price. Conversely, a 15% decline in earnings might lead to an increase in share price if investors expected a 30% decline.

In the end, stock prices tend to stabilise at a level matching the company's perceived prospects. Unexpected positives present opportunities just as unexpected bad results could introduce risk. It's wise to do your research about what market sentiment is before the results come out to be better prepared for any potential outcomes.

Let's look at some historical examples to illustrate the point.

Netflix’s stock slide post Q2 of 2018 earnings release
In July 2018, Netflix added fewer new subscribers than expected that quarter. Both Netflix's own forecasts and Wall Street analyst hopes were higher.

The disappointing report caused Netflix's stock price to plunge over 14% in after-hours trading following the news. Billions in market value was erased within hours.

This negative surprise raised worries among investors that Netflix's sizzling growth was slowing. It also dragged down technology stock prices more broadly in the days after.

So, Netflix missing its subscriber growth targets led to a massive immediate stock drop and ripple effects on investor confidence in the tech sector. It shows how lower-than-expected results can rapidly sink share prices as optimism fades.

Apple’s earnings for Q3 of 2012 exceeded market predictions
In July 2012, Apple reported much higher earnings than expected, thanks to a 28% jump in iPhone sales that quarter.

The positive surprise drove Apple’s stock up over 5% in after-market trading, reaching new record highs. When regular trading opened, shares dipped slightly to close at $600.92 – still up on the news.

Apple's blowout earnings boosted confidence not just in the company, but across the technology sector more broadly. Investor optimism grew that tech remained a strong investment area.

Apple's better-than-expected profits fuelled an immediate stock price surge. The exceptional performance also bolstered market spirits about tech's prospects in general. It shows how higher earnings can rapidly lift prices by feeding investor hopes.

Volkswagen’s 2022 - 2023 earnings expectations
In 2022, Volkswagen hit its target profit margin of 8.1%, doing better than in 2021. But its cash flows were €3.6 billion lower than expected due to supply chain issues.

The €22.5 billion in earnings matched what Volkswagen had predicted – a profit margin between 7 - 8.5%. The problem was their net cash flow missed the goal of €8.6 billion by a lot. Unstable auto parts supplies made it tough to stick to their budget.

Still, when Volkswagen put out predictions for 2023 in March, they were upbeat. They expected sales to jump 15% with profit margins holding steady at 7.5 - 8.5%.

This positive outlook got investors excited, driving Volkswagen's stock price up 13 points to over €142 per share. Even with the 2022 cash flow troubles, investors welcomed Volkswagen's rosy projections for strong auto demand and consistent profits going forward.

How to trade earnings reports

When it comes to trading based on corporate earnings reports, there are some risks involved because you never know how the market will react. That's why it's important to consider other factors like revenue growth, industry trends, economic conditions, guidance from management, and overall market sentiment. Doing thorough research and spreading out investments across multiple companies and sectors can also help mitigate risks.

With this said, how can you trade effectively by using the corporate earnings reports?

Factors to consider when trading earnings reports

Anticipate earnings reactions

Good earnings can rocket stock prices up. Traders rush to buy before it rises more. New investors may join in, betting on continued success.

But bad earnings make prices plummet just as quickly as folks sell to cut losses. That spooks more people into selling fast.

The challenge is working out if news will thrill or disappoint investors. If you think company results will beat expectations, you might consider getting exposure before the surge. If the earnings might disappoint you might want to get out of a position you already have or even bet against a rise in the share price.

Big surprises, whether up or down, mean volatile prices as investors instantly react. By correctly predicting if investor hopes will be boosted or let down, savvy traders put themselves in a position to gain.

Option strategies

Options trading allow traders to benefit from big stock price swings in either direction around earnings reports. Strategies involve buying both "call" and "put" options on a stock prior to the report.

Call options profit from rising prices, while put options profit from falling prices. These are often handy if you already hold a position and would like to mitigate your risk by taking an option in the opposite direction. For example, if you have a long position on a company but you expect their share price to experience a fall following the next results announcement, you can have a put option on the same company. By combining the two, traders cover themselves whether the post-report surprise boosts the stock up or sinks it down.

Just remember trading incurs costs. Be sure to understand how the fees associated with this strategy will impact your portfolio.

Using stocks for momentum trading

The goal when trading earnings reports is to capitalise on stock price movements after the news. If a positive surprise sends shares higher, traders quickly buy to ride the upward momentum. If a negative report sinks the stock, traders may short sell to profit off the falling trend.

The key is reacting fast to jump on accelerating prices in the direction of the surprise, then ride the wave of buying or selling activity until it starts fading. When the rise in share price seems to be slowing down or falling, it's time to take profits before the trend peters out or reverses.

Keep in mind that the market can be unpredictable, and these changes can happen in a flash. Ensure you have your stop losses in the right places to protect your portfolio from a sudden change in sentiment.

Managing risk

Earnings reports can trigger unpredictable stock price swings, increasing risk. Useful strategies to manage that risk include setting stop-loss orders. These automatically sell shares before losses get too large if the price moves the wrong way.

It's also key to consider overall investor sentiment and economic health. In gloomy markets, even good earnings might not lift prices. And bad news might get overshadowed during economic upturns or bull markets.

So, while surprises clearly impact sentiment, broader conditions colour reactions too. Cautious traders set stop losses, study investor mood, examine economic factors, and stay nimble reacting to reports. Preparation and risk control smooth out unpredictable bumps on the road to returns.

Risk management practises for trading earnings reports

Diversification of positions

It's risky to bet everything on one earnings report. If the market reacts unpredictably, you could take a major hit. Wise traders diversify across companies, sectors, and assets instead. That way no single report significantly sways overall performance.

Still, surprises influence investor optimism, often spurring a surge of buying and rising prices after good news or selling and falling prices when the results disappoint.

When you diversify your investments across many companies, no single earnings report will make or ruin your portfolio. However, paying attention to the reports gives useful insights into how each company is doing. The reports provide a snapshot of the company's prospects. The overall picture painted by earnings news across your portfolio can offer valuable insights to guide informed decisions.

In the end, earnings shape markets by swaying sentiment. Savvy traders use reports as helpful signposts, not lottery tickets hoping one stock strikes big . Careful portfolio-wide analysis directs trades, rather than betting everything on an unpredictable pick.