Clarifying Trading Around Earnings

This column was originally published on RealMoney on Jan. 31 at 1 p.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

One thing that is tough on so many traders is the issue of trading stocks around earnings. Here's the problem: Many stocks act calmly and rationally for about 10 or 11 weeks out of every quarter. But they start acting nutty right around the time when earnings numbers are announced. Why is that? Because traders are, for lack of a better way to say it, elbowing each other as they try to put their chips on the table. They're buying because they are optimistic that the numbers will be good or selling because they are pessimistic the numbers will be bad.

There are different intensities of optimism and pessimism, and the level of intensity dictates actions. If you are pessimistic, are you selling stock that you own, or are you actually shorting stock that you don't own? If you are optimistic, are you taking a new long position or just holding stock you already own? Or are you actually adding to an existing position to maximize your profit from the pending good news?

The way you treat trading around earnings is uniquely yours -- but your approach should be defined by your time frame and your cost basis. If you have a long time horizon (measured in years), then you must necessarily hold positions over earnings. You've done your homework, and you know the company. The earnings release is simply confirmation of something you already know. You own a solid company, and it's time to find out how your little superstar did over the past three months. ...