Earnings Up, Prices Down: A Deeper Look Into Irrational Earnings

 

I recently watched a video on YouTube where the viewer sent in a question wondering why and how a stock could have a great earnings report and still drop more than 20%. The exact question was:

“I have been trading for a year and a half now and I am a momentum trader. The latest big lost was a stock I own earnings just came out the other day which klled all estimates but it has been diving the last few days by about 20%+.”

“Since listening to your episodes, I normally don’t hold during earnings season, but I took a chance and it cost me big-time!.”

 “Do you have any thoughts on this? Any insight would be helpful. Thank you!”

 

Photo by Ken Treloar on Unsplash

Immediately I knew the answer to this question and continued watching to see how the YouTuber would respond as the “subject matter expert”. Now I’m not going name any names or hashtag any YouTube channel, but I must say I was quite disappointed by his response, although not much surprised. I know this YouTuber has been studying the stock market for much longer than I have, so therein lies the source of my disappointment.

 

Now the YouTuber wasn’t necessarily wrong. He gave a very complex explanation that failed to really deliver the point as the how this divergence between positive earnings report and negative price action could occur. Really, this question could have been answered in about a minute with another question: “Have you watched the news lately?”

 

Now that I typed that out, I realize that wouldn’t be much help either with the level of confusion added to the selloff chaos from headlines of various news articles. To give a better answer to the question, the selloff of the broader market is the reason those exceptional earnings means little for that stock’s performance.

 

Does this mean that all stocks should be dropping like a bag of bricks from a skyscraper? Of course not. I’m sure some stocks can be found that has found some strength in this weak market. (Permabull perspective)

 

However, we must remember the stock market is more about the investors and traders involved than the actual companies we are betting on. The change in price, a result of supply and demand, has more to do with the reactions of market participants than how well Company XYZ has performed for the quarter.

 

This is the main reason why seasoned investors like Warren Buffett see so much buying potential in bear markets. They understand the companies they are invested in to the point where they have a good sense of if that company can survive the emotional rollercoaster of irrational market correction.

 

Many investors, like the one who asked the question, fail to grasp this concept and get eaten alive as a result when things go haywire. This is another reason why conventional wisdom tells traders to not hold stocks through earnings because no one knows how the overall market will respond to the news.

 

Photo by Nigel Tadyanehondo on Unsplash

 

There are actually many more factors involved as to why stocks move irrationally the way they do through earnings but the least of those reasons has to do with the actual performance of the company.

 

As retail investors and traders, the only thing we need to be aware of is that things will rarely go the way we think they will and decide if we want to play the rollercoaster game or get out and wait for things to return to “normal”.

 

As I previously mentioned, the main thing to keep in mind is that stock prices have more to do with the people than it does the company. The people invested are the ones that directly affect the movement of price by their trading actions, usually based on emotions. And I didn’t even mention the algorithms created by those same people that contribute to much of the wild swings in price action, mostly seen intraday. But that’s another topic for another day.

 

Rob Will

Mv3Trader

Stay calm. Make a plan. Trade the plan.

 

Going Live: Transition to Real Money

At this point you have learned a ton about the market, created your very own strategy, and discovered the power of your winning strategy through back-testing and paper trading. Now you are ready to start earning real cash from all your hard work!

 

Photo by David Travis on Unsplash

You have made a great deal of progress but your journey as a trader is just beginning. As you start trading with real money your focus should now be narrowed down to two vital areas. First and foremost is your discipline for trading your strategy as designed. The second is executing your strategy to perfection.

 

By this point you should have become fairly comfortable with your strategy and have more than likely made a couple tweaks. As you paper traded your confidence, discipline, and execution should have also progressed.

 

However, switching over to real money in a live account is a completely different ballgame which can result in wild swings of your account balance. It doesn’t really matter how much money you are trading with that will spell the difference between success and failure. Keep in mind, losing on a trade is not failure. Losing on several trades is not failure. As long as you are trading your strategy consistently with discipline, you will be a successful trader. It’s really that simple.

 

You’re Wired to Lose

The difficult part is not allowing your basic human response to “danger” get the best of you. As humans, protecting ourselves at all costs is hardwired in us for the benefit of our survival. However, this works against us in the stock market.

 

For instance, going flat on an order when you see it start to eat away at those profits you gained on the first pop only to watch it bounce and return to where you exited as it continues to soar to the moon. Or hesitating to hit the buy button because you feel uneasy that the trade will work out.

 

Even for someone like myself who never really had any emotional ties to money throughout my life, still couldn’t avoid the emotional rollercoaster of trading real money. For me, it was more about being wrong with real money that allowed the emotions to creep in and make themselves comfortable in my trading home.

 

In this phase, don’t be shy to make some further adjustments as needed, but I warn you, DO NOT change your strategy here. I cannot stress that enough. If you have not mastered discipline and consistent execution, you are not ready to go to another strategy. Even if that strategy looks like the best thing since sliced bread. It doesn’t matter how much potential you see in this newly discovered strategy. If you are not disciplined enough to trade your original strategy consistently, win or lose, without letting your emotions take over, that “better” strategy will not make any long-term difference in your profit/loss column.

 

Just remember, there’s a reason you decided to take the strategy you created live. So, just stick with it until you are a trading machine reaping the benefits of consistent profits from your mastery of the art of disciplined trading.

 

The Cold Streak

Also, an important muscle to build is noticing when your strategy is just not working out that day, week, or month. Even strategies with the highest accuracy rating, fine-tuned to perfection, will have days where it just does not work. The market is the most dynamic environment for making money. Every single strategy will have days or periods of time when it just will not work.

 

Plus, there will be days where your strategy is fine, but you are just off your game. The best athletes in their respective sport has had games where their performance was far from their potential. Trading is no different and every trader goes through this regardless of their experience level.

 

You will need to develop rules to protect yourself during these unavoidable periods of struggle. For example, I have a protective rule I call “three strikes”. Typically, there’s only two futures contracts that I trade daily. If I’m wrong on a contract three times, rather I made a mistake, or the strategy just didn’t work, I’m not allowed to take anymore trades on that contract for the rest of the day. This rule has saved me from blowing out my account many times when the market had no life or was just doing its own thing, trading irrationally.

 

Contrarily, I’ve had days like August 3, 2018 where I broke my protective rule (see screenshot of Tradervue entry below) (Include link for journal entry aug 3, 2018) and paid dearly. There will also be times where this rule was triggered just to watch the move I was looking for finally present itself after taking the third loss. All I could do was watch the profits I could have had run away from me. But I can tell you with certainty that it’s better to follow your protective rules and start fresh the next day. Remember, the market isn’t going to shut down any time soon. It’s a marathon, not a sprint.

Click image to see my trades on Tradervue.
Startup Capital

So how much of your hard-earned money should you start trading with? That is completely up to your comfort level. Conventional wisdom says you only want to start trading with money you’re okay with never seeing again. You definitely do not want to lose any of your money. However, as simple as trading can be, not everyone can do it with consistent success. Some people just cannot get over the emotional mountain of trading with real money.

 

The stock market has one certified guarantee for all participants, which is you WILL lose money. There’s absolutely no way to get around it. If you just can’t separate yourself from your bottom line, maybe more passive long-term investing is a better fit for you, where you can just set it and forget it.

 

If you feel discipline is more of a struggle for you than the emotions, I would recommend starting with a small amount that will force you to make good decisions as you will have less of a cushion to fall back on. Once you have mastered being disciplined you can always add more funds to your account later. If you can grow a small account, you should have no problem growing a larger account. Just maintain the same disciplined strategy that helped you grow that small account. The only thing that would change is your account balance.

 

Go Forth and Crush!
Photo by Miguel Bruna on Unsplash

Congratulations, you have learned all the essentials to building your very own trading strategy and you should be well on your way to major gains! Now, all you need is the experience to go along with everything you have learned. Don’t get discouraged if you get off to a rough start. Even if you do like me a get off to a bang followed by a series of rough patches, remember it’s all part of the process. Manage your risk and stay disciplined with patience and you will have a long career as a trader. Just like with everything else in life, the more you do it the more you will improve. The challenge is lasting long enough to make it through the rollercoaster phase. Remember, it’s a marathon not a sprint.

23
Sep, 2018

Managing Risk Trading or Investing: Risky Business

The two key aspects to master as a day trader and/or long-term investor is the psychology and risk management. Getting over the psychological hurdles of trading is simply going to take time and experience. The risk management should be one of the first things you get down if you want to be successful over the long term. Managing risk trading or investing can be the one factor that makes or breaks your success in the market.

History Repeats Itself: Avoid Becoming a Statistic

We all have heard countless horror stories about people losing significant sums of hard earned money by an investment or trade gone bad. Most of these coming out of times like the Dot Com bubble or the crash of 2008 thanks to those infamous subprime mortgages created for failure. Those are just two examples of many crashes resulting in many people losing tons of money at the hands of the market.

From all the stories I’ve heard, at the heart of all the lost fortunes were poor or non-existent risk management plans. People would just put their money into whatever equity with no real thought into what if this doesn’t work out? How am I prepared for this company or the market as a whole running into disaster?

We all know in the market things can go south quick, fast, and in a hurry. With this simple oversight many people have loss literally everything on something as common as an inevitable market correction or bad news. Other than not participating in the market at all, there is no way around avoiding this risk. Rather you’re long-term investing, swing trading, or day trading, risk management is vital to your success in this unforgiving market.

So What is Risk Management?

Now when we talk amount risk management for trading what does that really mean? It’s quite simple actually. How much are you willing to lose on a single trade, in a day, in a week, or even in a month. The time frame really is up to you, but you need to know exactly how much you can personally stand to lose and still live to trade another day for as long as you desire.

Also, you need to ask yourself, “Is the amount I’m risking for this trade worth the reward?” There’s countless strategies and technique you can use to determine what your reward possibilities are, but conventional wisdom says the minimum risk to reward should be a 1:2 ratio. For example, if I’ve determined my risk to be $100, the trade is only worth taking if I have the possibility of making $200 or more without compromising my risk.

Remember you should never risk more than you are willing to lose. Many traders have failed from blowing out accounts due to little or no attention given to the risk. Losing streaks are inevitable for every trader. Having a solid plan will ensure you are able to make it through the storm.

How can a losing streak spell the end of your career or hobby as a trader? Think about this. If you have $5000 to trade, with a per trade risk of $100, taking 10 losses in a day can take away $1000 in one day! Repeat this and your account is down to 0 in less than a week.

Morale of the story? Beyond planning the risk per trade, part of your plan should also include how much you are willing to lose in a day, week, or month.

A good rule of thumb is your per trade risk should be no more than 5 percent of your capital. Ideally, you want to risk no more than 1 or 2 percent of your total capital per trade.

Developing Your Risk Management Plan
Managing Risk Trading
Risk management process that can be used for developing how you will mitigate the risk in your trading strategy.

There are many sources on the internet and in books that cover what a risk management strategy for trading should look like. One of my favorite sources that I used to help develop my risk management plan is reallifetrading.com. I didn’t follow their strategy exactly, mainly because their main focus is on equities and currently I’m only day trading futures, but the core of the risk management technique is at the heart of how I manage my risk. The most significant part to me is the way they remove looking at risk in terms of an actual dollar amount since there’s typically a ton of emotion tied into money. Instead, when viewing risk they simply refer to it as an “R”.

As a quick breakdown, let’s say my risk tolerance (using the example above) is $100 per trade. Now, you can just replace $100 with 1R. So instead of saying I am willing to lose no more than $100 on a single trade, you say I am willing to lose 1R on a single trade. You can try to say this out loud for yourself and see if you feel different saying 1R instead of $100 dollars. Like removing the innate emotion from losing money. Like a way of tricking the mind by removing the fear from trading since we know fear is the root of all evil when it comes to trading the market.

You can even take it a step further now that you have the understanding of what your R is and make rules for how many R you are willing to lose in a day, week, or even a month before stepping away from your trading station depending on how you develop your risk management plan. I highly recommend checking out Real Life Trading’s educational content since it’s 100% FREE!

You Have the Control

Risk management is a key element to the success of every business. Every successful trader and investor agrees that participating in the stock market should be treated as a business. Contrary to popular belief, earning money from the market is not gambling even though there’s a lot of similarities and the rush you can get similar to that of gambling in Vegas. What separates trading from gambling is the ability to control your risk. Take charge of your business. It’s only as risky as you make it.

P.S. Averaging down = no good!!!

Rob

Mv3 Trader