Welcome to second-quarter earnings season. The next three weeks of reports, surprises and disappointments will increase both opportunity and risk for traders and investors.

Unfortunately, most of us will get caught up in the excitement of this volatile period and make really dumb mistakes. We'll also fail to grab onto the low-hanging fruit because we're hypnotized by facts and figures and frozen by fear of the unknown.

The best strategy in the next few weeks is also the hardest one to follow if you're vulnerable to the gambling side of the trading game. Simply stated, play a stock aggressively into the minutes ahead of an earnings report but get out before the numbers are actually released. Then, after volatility dies down, examine the crowd's reaction and trade back into the position, if it still shows a good opportunity.

You heard that right. I said to get out of the market before the company actually releases its report. This small detail stands against the babble promulgated by analysts in chat rooms and on stock boards. It also goes against our hard-wired gun-slinging mentality that falsely claims we're smarter than anything Mr. Market can throw at us.

In truth, neither technicians nor fundamentalists can accurately predict price direction after an earnings release. This unknowable element exposes naive market players to unmanageable risk and career-ending shock losses. Since legitimate traders are not gamblers, we have no alternative but to step aside and let our competition play into the report and initial price swings.

Of course, the majority of the trading crowd believes the market is little more than a roulette table in which fortunes are made picking the right numbers at the right time, but nothing could be further from the truth. Our solitary legitimate goal is to take risk only when it can be quantified into measurable dollars and common sense.

In other words, it's a mistake to trade when we have no definable edge to exploit. This is exactly the dilemma we face ahead of an earnings report. And you're barking up the wrong tree if you believe that pretty charts give you that edge ahead of the news because, in truth, technical analysis fails miserably as a predictor of post-report price direction.

Symantec ( SMYC) bounced strongly after hitting its November low, jumping above the 50- and 200-day moving averages in April and hitting a seven-month high, just two days ahead of its May 6 earnings release. The stock was firing on all cylinders before the news, with strong accumulation pointing by healthy buying interest and a positive technical outlook.
Symantec (SYMC)
Source: eSignal

The company beat earnings estimates and issued in-line guidance, but that didn't stop it from falling 17% and plunging through the broad layer of moving average support. Adding insult to injury, it's now July and price still hasn't recovered, so enthusiastic buyers into the report haven't had a single opportunity to "get out even."

In reality, it doesn't matter if a company exceeds, meets or fails to meet analyst expectations despite the chatter about whisper numbers and profit growth, because there's a huge disconnect between the news and subsequent reaction. I challenge you to argue that point because we've all watched in jaw-dropping awe as stocks beating their numbers sell off violently, while those confessing gut-wrenching shortfalls deliver amazing rallies.

Of course you'll miss profits standing on the sidelines when upside surprises trigger big gaps or runaway markets like today's Intel ( INTC) rally. Sadly, those events will fog your brain about all the times you became the ultimate bagholder after an earnings report and were forced to hold onto a loser for months hoping it would turn the corner.

It all comes down to self-discipline because the big score also opens you up to the big loss. Still don't believe me? Go back through your trading records, add your earnings winners and subtract your earnings losers. It's highly doubtful you're basking in the green glow of the plus column after two years of holding positions through these volatile events.

While risk through the news release is unacceptably high, the speculative period ahead of the report offers a great playing field because we can ride the coattails of trader-gamblers taking unwise positions or overplaying their hands. To engage in this predatory strategy, keep an updated list of release dates and pull up the most volatile issues in real time, looking for blind speculation or other inefficiencies that might yield good trades.

The hit rate for this strategy is amazing because there's a huge amount of dumb money acting and reacting ahead of big reports. As you'll note when stalking price action into these events, greed and fear persuade weak handed traders and ill advised investors to bid prices into extreme levels. Of course, insiders quietly fan these emotional flames because it will yield better prices to buy or sell short after the news.

The pre-earnings game starts a few days before the release, as you can see with the Goldman Sachs ( GS) rally between Thursday and Monday afternoon. In a bullish scenario, look for prices to push into an old high or through a resistance level. Pre-earnings rally momentum can last into the final minutes ahead of the release so don't exit positions too quickly. Invariably, the laziest gamblers in the group will be checking the calendar and jumping in right near the close.

Goldman Sachs (GS)
Source: eSignal

How should you handle your long-term investments during earnings season? Well that's another ballgame entirely. Investors can't worry about short-term swings because high volatility is just part of the game. However, these folks can still reduce risk if they choose by purchasing options pairs that dampen the effect of sharp movement in either direction after the news.


Alan Farley provides daily stock picks and commentary with his "Daily Swing Trade" newsletter.


Know What You Own: Major financial stocks include JPMorgan Chase (JPM), Citigroup (C), Wells Fargo (WFC), US Bancorp (USB), Bank of America (BAC), Deutsche Bank (DB) and Morgan Stanley (MS). For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.

At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Alan Farley is a private trader and publisher of Hard Right Edge, a comprehensive resource for trader education, technical analysis, and short-term trading techniques. He is also the author of The Daily Swing Trade, a premium product that outlines his charts and analysis. Farley has also been featured in Barron's, SmartMoney, Tech Week, Active Trader, MoneyCentral, Technical Investor, Bridge Trader and Online Investor. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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