In our Winning Edge options service, which specializes in using options to trade corporate earnings and other market events, we frequently mention “sentiment” and “expectations.”
Investor sentiment is simply the collective feelings and actions of those in the market. And we’ve found that the most accurate sentiment indicators generally reflect what investors are actually doing (what they’re buying or selling) rather than what they’re feeling and saying (poll results), although both have validity in our analysis.
Why do we consider this important?
Without an understanding for the behavioral environment surrounding a stock, we don’t feel that our analysis is complete. You may very well know the fundamentals and technicals, but often it’s the sentiment — or behavioral — backdrop that makes the difference.
We’ll explain how to use sentiment to your advantage when trading and give you six earnings trades that could score you big profits if you act quickly.
Using Sentiment to Gauge the Market’s Real Expectations
Have you ever seen a stock drop in price despite an earnings report that met or even beat expectations? Or one that rallies furiously after merely meeting expectations? Why does the stock seemingly move against the fundamentals?
The answer is often contained in the differing sentiment environments surrounding the two stocks prior to the event.
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In one case, the sentiment may have been excessively bullish heading into the event, which creates high expectations of a blowout report (ever heard of the earnings “whisper number?”). This also creates what is called a “crowded trade,” which leaves little money to flow into the stock after the earnings release, no matter how positive the report.
On the other hand, there could have been a build-up of put options in anticipation that earnings might be missed. In this case, the expectation bar is set so low that meeting earnings projections is considered a positive for the stock. The result is that cash that was withheld from the stock based on pre-earnings pessimism pours into the market, pushing up demand and the share price.
This example points out a feature of using sentiment that some find intuitively difficult to grasp. A stock with relatively low expectations (pessimism) stands a good chance of rallying, as there is plenty of sideline cash available to boost the price.
Conversely, high expectations (the crowded trade) can put downward pressure on a stock, as there is little to no sideline cash to drive the price higher. In fact, the path of least resistance for cash is to flow out of the stock, resulting in declining prices.
Going Against the Crowd
So where do fundamentals and technicals fit in our behavioral valuation approach?
We’ve established the concept that pessimism can be beneficial (note that we did not say “is always beneficial”) for a stock or sector, while optimism can be damaging. In other words, sentiment can be a contrary indicator. And the power of sentiment is much greater when it runs counter to the direction of the stock (pessimism during an uptrend, optimism during a downtrend).
For example, one would naturally expect pessimism for a sector that is trending lower. So sentiment isn’t helping us find an edge. But what about pessimism during an uptrend?
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Here we have a contrary indicator (pessimism) that is running counter to the technical uptrend. And this is a powerfully bullish combination, because it tells us that the crowd has not yet bought into the rally.
In fact, we don’t usually see a sector or stock top out until optimism has hit an extreme. In the same vein, sectors tend to form a bottom when pessimism hits a relative high point.
Have you ever heard the saying that “rallies climb a wall of worry” or that downtrends fall down a “slope of hope?” These follow the same principle of contrary indicators (sentiment) running counter to an established technical or fundamental trend. Identifying when such powerful situations occur is the key to our behavioral valuation approach.
6 Earnings Trades
The key to finding the right sector or stock is to find situations in which pessimism is evident during an uptrend (for a long position) or optimism is present during a downtrend (for a short play).
Objectively gauging sentiment can add substantial value to traditional technical analysis, because sentiment extremes are not visible on the charts and can only be viewed and measured by a separate class of sentiment indicators.
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The tables below display information used to help determine potentially bullish and bearish trades.
Bullish Earnings Trades
The following stocks appear to be lining up to be potentially bullish earnings trades for next week.
|
Company Name |
Ticker Symbol |
4/22 Closing Price |
50-day Moving Average |
Current Sentiment |
Earnings Date |
Profit Growth Expectations |
|
Mylan Inc. |
MYL |
14.1 |
13.02 |
Pessimistic |
4/30/09 |
211% |
|
Waste Management |
WMI |
27.05 |
26.25 |
Pessimistic |
4/29/09 |
-13% |
|
Starwood Hotels |
HOT |
17.96 |
13.2 |
Pessimistic |
4/30/09 |
-93% |
Bearish Earnings Trades
The following stocks appear to be lining up potentially bearish trades for next week’s earnings reports.
|
Company Name |
Ticker Symbol |
4/22 Closing Price |
50-day Moving Average |
Current Sentiment |
Earnings Date |
Profit Growth Expectations |
|
Travelers Companies |
TRV |
39.93 |
39.35 |
Optimistic |
4/30/09 |
-19% |
|
Aetna Inc. |
AET |
24.53 |
25.27 |
Optimistic |
4/29/09 |
1% |
|
Dean Foods |
DF |
19.49 |
31.12 |
Optimistic |
5/1/09 |
83% |
For more on trading earnings, see:
And for more of our earnings trading ideas, be sure to check out the Earnings Spotlight section of OptionsZone.com, where we regularly provide you with earnings trades.
Chris Johnson and Jon Lewis are the editors of The Winning Edge trading service designed to help you make options profits around corporate earnings and other market events. For more information about them, read their bios here.
