The stop-loss is always an important tool for growth and momentum investors (although it’s rarely used by value investors), but never more so than during earnings season. Understanding the best way to use a stop-loss at this time should improve your results.
The fact of the matter is that earnings season tends to be a time of heightened volatility for stocks as the normal push and pull of the market forces run headlong into a binary event.
It’s an oversimplification, but stocks either hit (or beat) earnings targets, or they don’t. Either way, investors should expect to see some big moves in share prices.
Where that spells trouble with stop-losses is that earnings are reported outside of market hours, and gaps up and, more importantly, down are a common reaction.
If you own a stock at 60 with a 10% stop-loss at 54, and the stock gaps down to 52 after a particularly bad earnings report, your stop will be triggered and you’ll sell at the next available market price, 52.
If the stock keeps trading lower throughout the day you would have prevented a bigger loss, but if the earnings response is an overreaction and shares quickly rebound higher, then you’ll be kicking yourself for having the stop-loss in place at all.
It’s an inherent risk of the “mechanical” stop-loss orders that you enter with your broker.
Removing those stop-loss orders immediately before earnings is one option, but it carries its own risks. You can also widen your stop-loss orders by, say, moving a 10% stop-loss to 15%. The downside there is that you may face the same conundrum, just at a lower price.
2 Alternatives to a Stop-Loss Order
There are several popular alternatives to using a traditional “mechanical” stop-loss (where you’ve entered a sell-stop order with your broker), like using mental stops or mental stops on close.
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Mental Stops
A mental stop is simply a support level that, if violated, will prompt you to manually sell shares. This offers the benefit of allowing you to manually enter a sell order at a time you feel is appropriate and reduces your risk of getting caught up in a wave of selling that temporarily plunges the value of your shares.
If the shares bounce back immediately once that wave passes, you’ve saved yourself money on the trade. If, on the other hand, that wave was just the beginning of selling pressure, you could also find yourself facing greater losses. Having a sense of prevailing market sentiment and how your particular stocks trade can offer some insight into which outcome is more likely during earnings season.
Mental Stops on Close
Another option, which mutes the noise and intraday volatility of sell-stops and mental stops is to disregard the intraday price action of a stock. In this case, you’ll still establish a support level for each of your stocks, but a violation of that level will only prompt you to sell if the stock closes the trading day below support.
When that happens, it will be a signal to sell during the next trading day, regardless of whether the stock rebounds the next day (in most cases).
This is a better option for long-term investors than for short-term traders. Using the closing price can help de-stress trading stocks that you’re bullish on in the long term at the expense of seeing selling continue the next day.
So keep your stop-loss (or mental stops) in place and watch the news closely when your companies’ stocks are due to report during earnings season. If you’re not sure when that report is scheduled, you can find it at finance.yahoo.com. Go to the main page for your stock and click on the “Analysis” link on the page. If your company has announced the date for its earnings report, it will show up there. If you’re looking for a broader resource for stocks reporting during earnings season, Nasdaq offers a useful earnings calendar.
How do you set stop-losses on your portfolio positions?
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