Have you ever noticed how stocks go up or down by a wide percentage after reporting quarterly earnings results? Almost like clockwork, investors will reward or punish stocks that beat or miss Wall Street estimates.
It may be far from efficient, but it happens time and time again.
How would you like to own or short stocks set to rise or fall before the move takes place? Being on the right side of a stock that pops or drops after reporting earnings can result in huge gains. All that is needed is a strategy for predicting how a company is likely to report earnings and the most likely direction that a stock will trade as a result.
Over the last two earnings reporting seasons, I have identified huge winners including several stocks that gained 20% in just one day of trading. In 10 weeks of selections starting in January, my picks generated a gain of nearly 50%. In the next quarter beginning in early April, nine weeks of selections produced a 24% gain. The trades were made before earnings were released and then closed the next day.
It is a powerful approach. Here are five tips that can help you do the same:
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 current stock price?
The answer to these questions will give you clues as to the future. There is a tendency for stocks to trade in a narrow range before earnings are released. Nobody wants to be on the wrong side of a trade and therefore volatility is limited. If that happens when stocks in general are moving higher, there is the potential for gains. If your analysis suggests that an earnings beat will be forthcoming, you have the ingredients for a winning trade.
The short-term price history of a stock about to report earnings is the first step to profiting from this sort of trading.
Short-term technical factors
We are seeing the stock market bounce back this week after bouncing off technical lows. These support levels apply to individual stocks, too. Traders can get use the 200-day moving average to help guide moves during earnings season. Knowing the top and bottom of a stock’s trading range helps 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. A reverse head and shoulders suggests the potential for a bullish move higher. Identify such a pattern in advance of earnings gives me much comfort of what is about to transpire.
Most traders avoid trading stocks during earnings season. The unpredictable nature of the event creates too much uncertainty. I disagree with those that avoid such stocks. Instead, I apply common sense and jump in eyes wide open.
Wall Street estimates
The beat the number game on Wall Street is alive and well. For whatever reason there is a strong reaction by investors after a company reports results. Temporarily, there is an influx of buyers and sellers. The matching thereof is what determines price instead of things such as valuation.
When supply and demand are erratic, you get volatility. It is that volatility, however short term in nature, that creates opportunity for those trading stocks in advance of earnings. Make the right trade and big bucks can be made.
The first place to look with respect to earnings predictor trading is to examine changes in estimates during the quarter in question. Compare those changes to actual events to determine if Wall Street is on the mark.
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. The business cycle in relation to Wall Street estimates is also relevant. In the early going of a new cycle, estimates are often too low. The same is true at the end of a cycle when estimates are too optimistic.
Again, the idea here is that using Wall Street estimates to determine pricing in the market is inefficient. Traders can take advantage of that inefficiency by trading in advance of results.
At the end of the day, valuation matters. Specifically, trade stocks that trade for low valuations in relation to expected profit growth. If earnings results are better than expected, these low valuation stocks can rocket higher after an earnings report.
Ironically, I do use Wall Street estimates here to determine valuation. The most promising stocks tend to trade for low multiples of earnings with those earnings set to grow at a rate higher than the multiple. While not failsafe, in most cases investors can make money owning stocks with such a metric. Conversely, higher-priced stocks must keep beating estimates to maintain momentum or value will drop. Valuation is one of the best ways to find stocks that will win or lose during earnings season.
Performance against estimates
Finally, look at how a company has done against earnings estimates historically. A history of beating results is likely to result in a repeat performance. If there are mixed results, the difficultly increases to predict the outcome for the current quarter.
The biggest moves in the market during earnings season comes from stocks that beat estimates by a wide margin. When a company does beat by a wide margin, Wall Street tends to be skeptical and will be reluctant to increase future expectations. The analyst wants to see the money before a change to the estimate will be made. Even then changes tend to be too small.
Consider the earnings from Apple (NASDAQ: AAPL) results during the last two quarters. Its performance over the last year would seem to dictate an analyst estimate that should be much higher and yet quarter after quarter the estimate is too low.
This key is remarkably simple. The 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.