Earnings Surprises and Earnings History

Publicly traded companies file an earnings report each quarter detailing their financial performance over the previous three-month period. These reports list profits/losses for the recently concluded quarter, revenue, expenses, and any other financial metrics deemed materially relevant by company management. Quarterly earnings reports may also include a forecast for the coming quarter(s) or the remainder of the fiscal year.

While many corporations align their fiscal year with the traditional calendar-based quarters, others follow their own unique schedule. There's typically a rush of quarterly reports released every January, April, July, and October, resulting in several busy weeks known as "earnings season."

These regularly scheduled financial updates give shareholders a detailed look at how the company managed its business over the past few months -- whether sales increased or declined, whether margins expanded or contracted, whether a newly launched product lived up to expectations, and so on.

Prior to the release of these results, sell-side analysts at brokerage firms will issue their own estimates for the company's expected earnings (or losses) in the given quarter. All of these estimates are averaged into a consensus forecast, which is then used as the benchmark against which the latest quarterly figures are judged. Surprises can occur to the upside (stronger-than-expected results) or the downside (weaker-than-expected results).

Overwhelmingly, U.S. companies listed on the major stock exchanges report their earnings according to Generally Accepted Accounting Principles, more commonly known as GAAP. This simply refers to a uniform, standardized set of accounting procedures used industry-wide to ensure a consistent methodology is used from one set of books to the next.

A company may also issue what are called non-GAAP (or "adjusted") results, which often exclude certain one-time events, charges, or financial gains. This non-GAAP figure is the one that's typically compared against the expectations of various brokerage firms to determine whether the firm came in ahead of or behind the consensus analyst estimate.

Let’s take a look at ABC Corporation’s second-quarter earnings report, where the company announced a profit of 35 cents per share. In last year’s second quarter, ABC earned 30 cents per share, and expectations for the recently concluded quarter called for just 33 cents per share. These results definitely qualify as an upside surprise, topping both analysts' expectations and comparable results from a year ago. Typically, this kind of positive catalyst might trigger a move higher for ABC shares.

However, what if ABC tops expectations and the stock drops? Such an outcome would suggest investors' expectations were perhaps unreasonably high heading into the earnings report. Conversely, when a stock advances in the face of weaker-than-expected results, it's likely because investors had their expectations set far too low.

Unlike a number of other news events, a company’s earnings report is, generally speaking, a known event with a set date. This is an opportunity a trader can take advantage of by playing options either ahead of the earnings announcement, or after the company reports its results.

Playing options ahead of a firm’s earnings report is risky, though it can certainly result in large profits if the directional move is predicted correctly. Following the news release, the unwinding of extreme sentiment toward the shares -- whether bullish or bearish -- could contribute to a prolonged directional move.

As a result, initiating a trade after the earnings report can be just as profitable as a serendipitous pre-event play, while reducing some of the risk.