Playing Earnings – Zero or Hero

• Posted by DynamicHedge
• on July 7th, 2010

When trading equity pairs it can be very tempting to hold positions through earnings.  Particularly when you have a pair that you have held for a long period of time.  On the one hand, a favorable report on your long stock or a disappointing report on your short stock can produce a huge win.  Unfortunately, many times you will be on the wrong side of a move which leaves you underwater in the trade.  If you are loaded up in capital you will have very little  room to maneuver and will either have to cut the position or hope the position comes in and ride out the loss.  My rule of thumb is that I rarely hold full-sized positions through earnings.  I will only consider holding if I have a heroic fundamental edge and multiple catalysts on my side.

I’ve enclosed a chart that illustrates perfectly why I feel it is prudent to either avoid or size down during earnings season.  The pair is DLTR vs FDO, two discount retailers.  I prefer this spread from the short side, and I’ve been playing it for the last few weeks.  Yesterday I reduced my position down to 1/6 size because FDO was reporting earnings after the close.  My trading plan for this spread allows for six units of capital.  I came into the morning with three units short and I took two units off at the close, leaving me with 1/6 of my total position size at the close.  FDO had a disappointing earnings report after the close and traded down almost 8% in the following session, while the short side of the spread,  DLTR, only traded down 3%, thus producing the gap in the chart and divergence in the spread.  Reducing the units of capital into an unpredictable event allows me to continue trading the spread without the handicap of a large open loss.

There are many predictable elements to spread trading, but I feel that earnings reports are one of the least predictable.  The proof is in the chart itself, it contains many gaps in both directions and they are all due to earnings.

In the long run I feel that the spread trading in this upper range is a great opportunity otherwise I would have stopped out of the position entirely.   I will stay away for a few days and let the probabilities to stack up before I get back in.

Always control your losses and size your bets correctly for the odds.  Managing your risk in low probability situations is critical.

DLTR – FDO pair (Click image to enlarge)

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