In today’s option trading blog I will discuss earnings announcements. Traders are paid to predict the future. When they perform well, they are rewarded. When they perform poorly, they find new work. Earnings carry uncertainty and a diminished ability to predict.
Playing the actual earnings announcement is pure gambling. I have seen stocks with great earnings get smashed after they exceeded estimates. I have also seen stocks that looked like they were going bankrupt, rally after another losing quarter. Sometimes stocks do the expected, sometimes they don’t. After years of trying to model an earnings trading system, I have found the event too random.
On the other hand, once earnings have been announced, I scour the market for stocks that have outperformed and have raised guidance. I analyze corporate comments to determine why business is so good. Stocks with one time extraordinary items are cast aside. I seek stocks where the conditions will be intact for at least six months. A buying opportunity will present itself once the excitement of the release subsides. Earnings provide a brief glimpse into the future. The same is true (from a shorting perspective) for stocks that have disappointed and lowered guidance.
These surprises create a gap and the stocks are instantly on my radar. The actual gap might present an opportunity, but the stock usually attracts too much attention. If I get in at a good price right out of the gate, I will often hold a partial position overnight if the stock closes on the high. The problem with day trading is you have to be nimble. The news has attracted momentum players and at any moment, the move can reverse. The better trade will come after the news has been defused.
A few days after the news has hit, the trading activity settles-in. This is when I can determine if it has any fuel left in the tank. The bigger the initial move, the greater the chance for a small short-lived reversal. I know this because the day traders need to be shaken out – they have no conviction to the stock, they were just looking for a quick buck. Once that reversal fades, you will have a nice entry point for the next leg up. If the first move created a breakout, I watch for the reversal that tests that level (now support). If it holds, I have a nice entry point.
The exact opposite holds true for stocks with negative news. Often you will see a stock with a current quarter that beats estimates – get spanked. They have lowered future guidance. To a degree, I feel the market factors in the chance for better earnings. That anomaly may have resulted from Sarbanes-Oxley where corporate executives want to underestimate/over-deliver. Regardless, the market discounts the future and places a premium on that part of the news. This is one reason why “misses” are dealt with severely.
My favorite set-up happens when a hot news item is suppressed by a weak market. The stock wants to rally, but a weak market keeps a lid on it. As soon as the market regains its footing, the stock takes off. Watch for these situations and monitor the stock on an intraday basis relative to the SPY. A chart that overlays both will reveal any relative strength.
As earnings season approaches, I am looking in the rear view for what has been announced. That is where I can find certainty and where I have the best chance of predicting future price movements.
Two final notes. I do trade pre-earnings patterns, however, those trades are closed before the announcement. That set-up will have to be covered in another article. Secondly, I may have longer-term positions that I will carry into earnings. They are by nature intended to “weather” theses events. I like the position and I’m confident that long-term I’m on the right side of the trade.
If you have an announcement that you think presents an opportunity, post a comment and tell me why you think so. I will try to respond with an approach.