When trading stocks, it’s important to know which kind of events can make the market go up or down. One of these events is a profit warning. Let’s discover what a profit warning is in this article, as well as how you can take advantage of it in your trading.
What is a profit warning?
A profit warning is issued when an organization informs investors and the public that it expects its financial performance to fall short of market expectations prior to reporting its formal earnings at the end of a quarter.
If companies know that their earnings will fall short of analyst projections, they have an obligation to inform shareholders and the stock market. When a profit warning is issued, it’s also important for the firm to explain why. It’s actually illegal to mislead investors or the public about a public company’s performance, so this is done to rectify any inaccurate projections or statements that have been made in the past.
Most of the time it’s the negative profit warnings that are widely reported by the media, but often companies release positive expectations for their earnings reports too. It’s frequently been said that the phrase “profit warning” itself is confusing and misleading because it sounds like a loss in revenue. In reality, it just means that a financial estimate is being released ahead of the actual results that could be better than expected or worse than expected.
For the purpose of this article, we’ll focus on keeping your capital safe in the event of a negative profit warning. Read on to learn what happens and how you can respond to ensure the best results.
Which factors can trigger a profit warning?
Some investors might be caught off guard when profit warnings are issued due to a wide range of causes. Sometimes there can be internal factors at the company, such as a drop in sales, issues with a product, the failure to meet contractual obligations, changes in management, or poor financial decisions.
There can also be problems externally that are outside the control of the company, such as problems in the supply chain, the general state of the economy, inflation, changes to consumer buying habits, interest rate increases, and currency exchange rates among other things.
Last month, it was reported that the UK was at the time experiencing the highest number of profit warnings for over a decade. Not since the global financial crisis hit in 2008 has there been so many, with 86 companies warning of worse profits in Q3 2022, compared with 51 in the same quarter last year.
In Great Britain in particular, companies that were already struggling with many supply and demand issues caused by the Covid-19 pandemic, are now more recently dealing with the soaring cost of energy and a large shortage of workers. The price cap on Russian energy expenses might help in the short term, but once it’s lifted incrementally next year, many companies will face even more pain if the Russian conflict with Ukraine continues.
What happens to the price of a company’s shares when a profit warning is issued?
A positive profit estimate is usually good for share prices as it means investors will see an opportunity for growth and stable investment, thus causing the share price to increase.
A negative profit warning can go both ways, depending on the issues at play.
It can be bad for the share price in the immediate term if investors are spooked and fail to do any follow-up research to understand the situation. If the profit warning is the result of a clearly identifiable problem that seems to be fixable by short-term management initiatives though, then it could be an opportunity to buy the shares at a discount and the price to diversify your portfolio could remain stable.
If the decrease in expected profits is a result of issues that are obviously not redeemable, then it may be a good time to cut your losses and move your capital elsewhere. If enough investors do this, then the share price will subsequently tank.
How to take advantage of profit warnings in your strategy?
When investing in the stock market, you can expect to see your fair share of profit warnings that are less than encouraging. The best course of action is to remain calm and see whether the situation can be improved. If they are unable to, you may have to contemplate selling at a loss. Let’s look at some ways you can turn a warning into a win.
Contracts for Difference
A Contract for Difference (CFD) is a contract between a trader and a CFD broker. A CFD is a kind of derivative financial instrument whose value tracks that of an underlying asset, enabling gains or losses to be realized depending on how the underlying asset’s price fluctuates in comparison to the open position.
Investors may hedge their bets against unfavorable price swings in the market as a result of a profit warning or cut their losses using CFDs. Opening positions with rapid execution that may serve as a hedge against other transactions, such as a big portfolio of equivalent market equities, is one way to do this. You can also profit from the price fall by using short-selling.
Do your research
If you’re going to be a profitable investor, it’s crucial to make logical and unemotional choices at times like these. That requires taking profit warnings on an individual basis and looking at the underlying causes.
You’ll need to ask yourself a few key questions:
- Has the cause for the profit warning significantly altered the long-term profitability of the company?
- Has the risk of irreversible capital loss from the stock reached a critical level?
- How low might earnings go before it became difficult to make interest payments on borrowings and adhere to debt/profit covenants?
Patient long-term investors may be able to make a good purchase after a profit warning, depending on the answers to these and other questions.
It’s important to refer back to your trading strategy and decide whether your evaluation of the company meets your predetermined risk profile before moving forward. As with all of your investments, never put more capital at risk than you’re willing to lose.
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