A Trading Strategy For Energy Earnings

Earnings season, the gift that keeps on giving for US stock traders and investors, is underway, with results for the quarter that ended at the end of September beginning to trickle in. On the energy side, big oil and other significant companies in the sector aren't typically among the first to release results, and this quarter is no exception. There will be a couple of reports of interest in the coming week, Tesla (TSLA) on Wednesday and Schlumberger (SLB) on Friday, but energy doesn't really get going until the following week when Shell (SHEL) releases their earnings on October 26th. So, it may seem a bit early to talk about energy earnings, but that isn't the case if, like me, you avoid trying to trade the actual news and instead trade the buildup and the reaction.

There are several reasons why I do that, but the most important is the blunt realization that if I try to react to any news, and particularly anticipated news like an earnings report, I am at a major disadvantage as an individual trader. I will never beat institutional traders, whether human or algorithmic, in terms of speed. They will receive the news faster, react quicker, and have significantly faster execution times for a trade, and trying to beat them just means starting every trade at a disadvantage. For that reason, over my years of transitioning from being on a desk to trading in my own account, I have shifted from reacting to news to trying to guess what others will do going into an expected release or looking for a retracement of an overdone initial move after the event.

In the case of energy stocks this quarter, logic suggests that there will be opportunities in both of those areas in the coming weeks. However, to take advantage of them, you can't wait until right before the releases, but will have to start quite soon.

Typically, energy stocks track the price of oil quite closely, at least in terms of trends and directions, as you can see by comparing these two charts, for energy stocks as represented by the SPDR Energy Sector ETF, XLE, on top, and oil futures (CL) on the bottom.

That is perfectly logical, but during earnings season, that relationship often breaks down. Traders and investors are focused on past profitability as results come in and current oil prices have no bearing on that. What matters there is the price of oil during the three months just gone and, as you can see from the CL chart, that has been positive for oil companies. There has been a pullback recently, but the high of $95.05 was hit just a day before the quarter ended at the end of September.

Because of the usual direct correlation between oil and energy stocks, XLE has followed the same path, rising for three months before a significant pullback so far this month. However, when oil companies report in the coming weeks, they will be reporting results from when oil was buoyant, so big profits are likely. Everybody knows that, of course, but so far, earnings have been too far away to enter into calculations and the drop in oil has dragged sector stocks with it. That will change over the next few trading days.

So, the logical thing to do is to buy something like XLE, or maybe a few big oil stocks like the aforementioned SHEL, or XOM, or CVX, or whatever, in anticipation of that adjustment. If oil falls again after spiking on the Middle East situation you may not make money on those trades, but the shift of focus to average oil prices through the last quarter means that even in that scenario, you probably won't lose much, and the upside if crude even just remains relatively stable is large enough to make the risk worthwhile.

Then there is the second leg to the trade. As I said, this is hardly a secret. Everyone knows that Q3 was a period of high oil prices that will most likely lead to good earnings and will be trying to position accordingly. However, when everyone gets one way on any trade, it sets up the "buy the rumor, sell the fact" scenario, and I will be shifting based on that as earnings come out, selling, and maybe even going short for a while.

I may not be able to get in front of institutional traders in terms of reaction time to news, but what I can do is try to initiate a position in front of what logic dictates they will do in the couple of weeks leading up to that news. That is the plan here, and if it works as expected, there will be a second part to the trade based on the same idea of anticipating a reaction by selling and going short on any initial pop that may follow any good results. That isn't a foolproof plan, of course, no trading strategy ever is, but it does give me more chance of success than trying to react faster than the market to expected news and data.