Traders tend to be avid philosophers.
We love to ask lots of “why” questions.
Why does one stock go up while another with similar characteristics goes down?
Why do two completely different strategies, such as technically-based trend trading and fundamentally-based value investing, BOTH yield massive fortunes in the long run?
Why do many people go broke trying to implement the exact same strategies used to make millionaires and billionaires out of others?
One such “why” question I’ve been reevaluating lately is why we choose to sell or not sell a stock prior to the company’s earnings announcement.
There are basically two schools of thought when it comes to this issue:
Option No. 1: It’s just too risky to hold a position into an earnings call. This is one news event that we DO see coming and therefore, we should sell our position prior to the news and evaluate the stock afterwards.
Option No. 2: The technical action leading up to the earnings announcement tells us all we need to know. If the trend is still valid, there’s no reason to sell before the announcement. Selling will only cause us to miss out on a potentially huge post-earnings profit. We therefore need to trust the technicals and ignore the news and rumors.
Option No. 2 was Nicolas Darvas’ approach. He found that his biggest gains came when he “walked away” from his positions and only evaluated them from afar, regardless of the news and events that were directly impacting those positions.
This is a valid approach.
I’ve noticed that when a stock gets hammered by an earnings announcement, it USUALLY flashes technical sell signals prior to the announcement. For instance, the stock will undergo heavy-volume selling and/or break below a key support level without bounce-back action.
Along those same lines, a stock that surges higher after an earnings announcement USUALLY shows signs of accumulation prior to the announcement. For instance, we’ll see the stock move higher on increased volume or bounce off a key support level right before the announcement.
In other words, buying correctly out of sound bases and learning to identify and trust proper support levels during a stock’s rise will USUALLY keep you out of trouble when it comes to earnings announcements. Signs of distribution will tell you the earnings news is likely to disappoint and signs of accumulation will tell you that even if the news IS disappointing, institutional buyers will likely be there to hold the stock up.
But yet, I recommend selling half of a position prior to an earnings announcement.
I take a middle position between the two approaches mentioned above. By selling half, I can still benefit from good news and a gap higher, but I also won’t get hurt too bad by disappointing news and a gap down. I remind myself and others that you can always buy back the other half if the news is good.
Why do I do this? Why do I recommend a rule like this?
After all, I can confidently say that, over the long run, you’re financially going to be about the same, but probably better off, just trusting the trend and holding onto a full position into an earnings call (assuming, of course, sell signals haven’t been flashed).
The reason for my “sell half rule” is simple. Because USUALLY isn’t the same as ALWAYS.
While you USUALLY won’t get hurt too badly by a stock that is still properly trending higher as it heads into an earnings announcement, EVENTUALLY you will find yourself holding onto a “perfect” stock that gets absolutely crushed by a bad earnings report.
And by “crushed” I mean helplessly watching a position fall 15%, 20%, or more!
Experiencing this kind of move is like taking a punch to the gut. You see all your profits that have built up over weeks or months suddenly evaporate in a matter of moments.
It’s a truly painful experience that can rattle a trader’s confidence and lead to some very dumb “revenge” trades.
Is that really my answer to “WHY” I prefer to sell half my position prior to an earnings announcement? Does it really come down to the old psychological dilemma about choosing the desire to avoid immediate pain over the desire to feel future pleasure? (In nearly all situations, humans instinctually choose to avoid pain in the present unless there is a clear and reasoned basis for withstanding pain now in order to experience pleasure later.)
My honest answer is yes. That is my reason WHY.
Selling half of a position prior to an earnings announcement makes me FEEL (and sleep) better.
If I’m completely honest with myself, my “sell half rule” is executed for EMOTIONAL management more so than for MONEY management. That is, I’ve found no evidence that my “sell half rule” – in the long run – leads to better per-trade gains. But, I HAVE personally experienced enough earnings announcements to tell me that my “sell half rule” is beneficial to my performance as a trader.
Ultimately, this leads to much better financial results.
A trader MUST learn to control his emotions just like he must learn to control his money. He needs to implement specific techniques to enhance his control over both.
Position-sizing techniques have a tremendous impact on money management and emotional management. In the world of trading, management of BOTH is absolutely critical.
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