I've been working on an options trading strategy recently, which would loosely be classified as "volatility arbitrage." As an experiment, I took some of the trades it implied on two stocks entering earnings announcements: GS and JNJ. Both were long, coupled with a short position in PG. The short position is less important to the experiment, but is necessary for reasons unimportant.
The reason I find this particular moment so fascinating is because, in my opinion, it is the truest test of a strategy. When earnings are reported, equities experience a rare moment in which the full information set that determines their value is available. There is something of a "reset" to the perceived fair value, in which all market participants have the same information.
The question is, will the earnings announcement disrupt my strategy, or actually bolster it? If a model works by correctly identifying the genuine value of a security, the earnings announcement should force a convergence to fair value, which would be beneficial to the strategy. If, on the other hand, it works by predicting the changes in investors' whims, and in fact does little to determine true value, the earnings announcement should disrupt the strategy.
Naturally, the optimal strategy would fare well in both scenarios. But how could that be? We must construct portfolios that are sensitive to a likely outcome (such as convergence to fair value) but still robust and immune to other possible scenarios in which investors misread the evidence.
Good luck...
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