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Trading Techniques: Bad Earnings Surprise

Trading Techniques: Bad Earnings Surprise
March 07
00:58 2012

Day traders and short-term traders are constantly seeking techniques that exploit certain predictable patterns in equity price movements. One such technique is the bad earnings surprise. It is a form of event pattern, so named because they are tied to specific events—a surprise negative earnings announcement, in this case.

Analysts following a company promulgate earnings estimates for each quarter. If the company announces earnings that are materially below the consensus estimate, this creates a negative surprise. Despite what you might think, however, this does not automatically produce a drop in the stock price. In a bull market, over 40% will nevertheless see a break upward, and in a bear market the proportion is even higher—over 60%. Of those that do break down, almost five in ten will bottom within a week and six in ten will bottom within two weeks. Because of these numbers, this pattern is only a middling performer, with an average decline of only 13% and a failure rate of 31%.

This pattern is most reliable in a bear market, and it is preferable to see a downward price trend leading up to the earnings announcement. The pattern is also best traded with a stock that is within a third of its 52-week low.

When earnings are announced, look for a sharp downward movement that day (or the following day if the announcement is made outside of market hours). Calculate the target low as follows: subtract the intraday low (not the closing price) from the intraday high on the day the market reacts to the announcement. Multiply that number by 0.69, which is an adjustment that represents the rate at which this stock pattern meets an unmodified downward break price target. Take the result and subtract it from the earnings announcement intraday low.

Once you have the target low, wait for confirmation of the downward trend—remember that a substantial number of stocks will actually head up. Once you have confirmation, you can expect that the stock will bottom within a relatively short period—half will do so within a week—so you will need to move fairly quickly if you intend to short. (Shorting such a stock is, by the way, the most aggressive means of exploiting this pattern.)

You may instead choose to buy once the stock hits its target low price, using a stop order to protect yourself in the event of further strong downward movement. If so, be prepared to sell (or set a stop order) once the stock returns to its announcement date intraday low. This is frequently the vicinity of where the stock will peak upon bouncing from its post-announcement low.

A further technique for exploiting a negative earnings surprise is to watch the next quarterly earnings announcement closely. About three-quarters of the time, one negative earnings surprise will be followed by another negative earnings surprise.

An example of this pattern can be seen with Valero (VLO). Look at a price chart for 2006, and in mid-April you will see where the stock peaked around $70, experienced a sharp fall on a negative earnings surprise, and then rebounded before pulling back even further.

This technique is much more suitable as a short-term trading technique than for day trading, since day trade positions are not typically held overnight, and this pattern will take days to a few weeks to fully play out.

For safety, use limit orders to automatically exit the position once the stock price has achieved the calculated target price. Bear in mind that short-term trading requires discipline to be successful. Don’t let greed tempt you into remaining in a position too long, or you may find yourself losing all of your gains and more.

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