Ivanhoff Capital – Page 301

The effect of earnings' surprises

I have been writting and reading extensivelly on the subject of reaction to earnings’ surprises and its effect on stocks’ prices in short-term and long-term perspective. As a prove you might see my view and links in the section “How markets work” and “Trading methods”.

About 2 years ago I got acquantant with the effect of earnings thanks to a trader named Pradeep Bonde. Today I noticed that he has a very good summary on the subject:

When a company has a earnings surprise or a miss, more are likely to follow. That is called the cockroach effect. So when you see one earnings surprise from a company more are likely to follow. That is what produces big trends. When you have one isolated company in a sector with earnings surprise, you can ignore it. But when you have so many companies in a sector coming out with surprise, take note.

Some of the most powerful and enduring trends lasting months or years are set in motion by earning acceleration or deceleration. If you look at any long term trend in stock or sector, you will find at the beginning of the trend a series of earnings surprise or acceleration. The oil stocks started showing significant earning acceleration in 2003 and the trend lasted for 4 years. The steel stocks started showing earnings surprise in 2003 that trend lasted 4 years. So when you have a sector showing earnings surprises take note.

IBD also has a good article on earnings today. They remind us about two factors that have to be considered during earnings’ season:

1) Earnings season can provide useful clues about the general market. If there is a shift in sentiment, you will see it in the way how market reacts to earnings reports.

A bear market punishes almost all stocks. Investors are in a bad mood and they are looking for the smallest weakness in an earnings report as an excuse to sell. Bear market is built on negative thinking.

Bull market on the other side is build on positive thinking. Investors are in a good mood and they are literally looking for a reason to lift stocks’ prices. If a company misses estimates, investors will be looking for a glimps of hope: a better than expected guidance or several possitive words from the CEO are often enough to send a stock higher, despite missing expectations. And if the company reports well above the expected and raise guidance, you will see it gapping double digit the next session. Bull market rewards performance and often forgives misses. It always sees the postive angle.

2) Be aware of the risks during earnings season. Holding a stock though an earnings report can lead to pain or gain. I personally preffer to deal with a stock after it reports. In the very rare occasions I am long in front of earnings, my position is very small and I always have an option postion to protect my equity.

4 types of trades

bond

Stock trading consists of 4 major types of trades.

The range-bound trade: the stock is tied in a range and will remain there until there is a significant change in the supply/demand dynamics. For this trade you fade any move to the boundaries of the range with a tight stop a little bit below/above the range. If the range is broken, you will lose small amount. It is good for scalpers with shorter trading horizon.

The breakout trade: in order to break from a range, a stock needs to experience a major shift in supply/demand. A dramatic occurrence. News or expectation of news. The news doesn’t have to be connected with the individual stock. It might be something that impacts the whole industry or market. Sudden change in participants’ confidence. Not every breakout will be caused by clear news. Often it will happen at no news at all. In any case, volume should be your tell how genuine the move is. Buy several cents above the range with a stop several cents into the range.

The reversal trade: not every breakout is genuine. Ranges are often manipulated in order to deceive market participants and free them away from their money. Again volume or more precisely the lack of volume should assist you in taking a proper decision. Once you notice that the breakout is fake and the move exhaust itself, fade it with a target the upper boundary of the old range and stop the high of the day.

The trend trade: high-volume breakout from an extended range often starts new powerful trend. Many traders complain that they have missed a certain breakout, without realizing that if that breakout was genuine there would be multiple other opportunities to jump on board as the new trend evolves. Trend trading consist buying/adding at the dips or selling/adding at the rips. Entries on pullbacks offer a lower-risk way to participate in an established trend.

All 4 types of trades occur on different timeframes. What looks like a breakout trade on a 10 min chart might be part of a range-bound trade on a 1 day chart. Traders should specialize in one type of trade and in one timeframe, depending on their personal skills and preferences.

Dr. Brett Steenbarger on identifying ranging and trading environment

Identifying early in the day whether we are in ranging or trending environment defines trading tactics going forward;
If we are in a range-bound environment, we’ll identify a midpoint value of the range and fade moves that extend from it;
If we are in a trending environment, we buy on the breakout and add at every low volume pullback until it works.
NYSE Advance/Decline line value during the first half an hour of the day is usually a good indicator for ranging or directional environment for the rest of the day.

High-volume break-outs from prolonged in the time range is usually a start of a new powerful trend. The larger the volume and the longer the consolidation level prior to the break-out, the better the odds that the newly established trend will continue.