This article originally appeared on Traders Reserve.

Q2 earnings season “officially” kicks off next week with Alcoa’s (NYSE: AA) earnings report scheduled to be released April 11. So now is the perfect time to cover some ground rules for trading earnings.

The market is far from efficient. As a result, traders are presented with opportunities to capitalize on market pricing in the market that misses the mark. All that is needed is a trigger and a game plan for maximizing profits and minimizing losses, and one of the best triggers for trading opportunities is the quarterly earnings report. Publicly traded companies rarely release information about operating results.

Investors are left to guess how companies are performing. When earnings are released we see just how inefficient the market can be with how it prices a stock. It is not uncommon to see a stock move higher by 5%-10% after earnings are released. That is not bad for a short-term trade — assuming you are on the right side of the equation before the news is released.

Is it possible to accurately predict how an earnings report will go and the subsequent trading action after the news is released? The answer is yes, and you would be surprised at how easy it is.

Last year, I began writing a column for a large financial website offering traders recommendation on stocks releasing earnings that week. Since the article first appeared in November, I have had a number of winners including some big gainers. I’ve had several picks go up more than 10% with my biggest gainer jumping more than 30% after releasing earnings. Sure, I have had my losers too, but for the most part investors won big following my advice.

Here is a summary of the five keys that I follow when making my recommendations:

#1 Current Stock Price

It may be surprising, but the current stock price of a company about to report earnings can provide traders clues with respect to future action. Has the stock been running up in advance of the report? Where is the stock trading versus the rest of the market? Has the company released guidance in advance of the earnings report? What other news out there is impacting the current stock price?

The answer to these questions will give you clues as to the future. For example, if a stock is trading flat when the rest of the market is rising, there is potential for big gains when earnings are released. Investors tend to get nervous in advance of earnings. The concern is a stock losing value on a bad report. If the report is strong, the reaction to the upside is powerful in that traders are making up lost ground while they waited for the report to be released.

#2 Short-term Technical Factors

Nothing fancy here. Traders can get a sense for where stocks are heading by simply looking at the 200-day moving average. Knowing the top and bottom of a stock’s trading range helps to determine the extent of an opportunity when earnings are released. A stock at the bottom of its range has the potential to move significantly higher on a positive report.

Another technical factor to look at is the one-year and three-month trading charts. What patterns if any are discernable to traders? Personally, I prefer the head-and-shoulders pattern. If I see the reverse head-and-shoulders setting up in advance of an earnings report, then I move the stock to the top of the list of potential trades.

Many traders loathe earnings season because action in the wake of an earnings report often contradicts long-standing trading factors. I take the opposite view. If I can get a sense of direction in advance of the report by using some simple guidelines I am ahead of the game.

#3 Wall Street Estimates

Love it or hate it, much of how investors determine price in a market is based on how a company does versus Wall Street estimates. The beat-the-numbers game is loathed by many, but is a surefire way to trigger volatility in a stock. Bet on the right side of the number and a trader can make big bucks in a short amount of time.

One of the first things I examine when looking for an earnings predictor trade is changes in estimates during the quarter in question. What was the estimate at the beginning of the quarter? What is the estimate just prior to the earnings release?

Typically analysts are slow to change their estimates. If there has been any sort of news on a macro or micro level traders can duly note such news. If the estimate has failed to move on the news, an opportunity is created.

Finally, where we are at in the economic cycle can often determine how a company does versus the estimates. At the beginning of a cycle, estimates are too pessimistic. Wall Street expects companies to prove it first. As a result, companies often beat estimates by a wide margin at the start of a new cycle.

Put it all together and traders can find lots of clues as to how a company will perform against estimates by examining these numbers.

#4 Current Valuation

Although a market may be inefficient, fundamentals ultimately rule the day. The way a stock fluctuates after releasing earnings is a reflection of a market attempting to be more efficient. If a stock trades for a low valuation in relation to earnings growth investors eventually get the clue.

In looking for earnings trades, I look exclusively at valuation in terms of price to earnings. I use Wall Street estimates to get an idea of future growth potential and compare that to the current trading multiple. If a stock trades for a low valuation and is expected to grow by a large percentage, there is an opportunity for big trading gains when the earnings report is released.

Stocks with a high valuation need to jump over a higher bar. It is not entirely impossible, only more difficult. Use valuation as a guide to how the market should be trading your earnings predictor stock.

#5 Performance Against Estimates

They say that the trend is your friend. I agree with that sentiment. If a company has a history of besting earnings estimates, there is a strong likelihood of a repeat performance. It is far more difficult to ascertain the future with a company that has mixed results against estimates.

The greatest opportunity can arise from a company that has beaten estimates by a wide margin. AS I said before, Wall Street is reluctant to increase earnings estimates even if prior performance suggests doing so. When the proof in the pudding comes in the form of another earnings beat the market reacts accordingly with a big pop.

This key is remarkably simple. The only risk is that sometimes trends end. When they do, a stock is likely to lose significant value. The protection is to know where we are in the business cycle and to utilize strict selling discipline in order to protect a trade when it goes wrong.

For more trades, ideas and strategies, visit Traders Reserve.

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