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Leigh Drogen, Estimize (587 clicks)
Hedge fund trader, long/short equity
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I've been through this lesson before a long time ago, but since it is one of the most important to teach, I'll go through it again. Understanding the flow of money into and out of a stock after a large upside earnings gap is extremely important if you are an intermediate or longer-term trader. The clues left behind in the price and volume from the day of or after an earnings report gives us an enormous amount of information regarding the way large institutions see the stock now, and are positioning for down the road.

For our purposes, we will use two specific examples, both from earnings reports two quarters ago. The first comes from LinkedIn's (LNKD) FQ4 2012 report. The appropriate EPS and Revenue charts from Estimize are posted below. Take note of the delta between the Wall Street consensus, Estimize consensus, and actual results from LinkedIn.

As you can see, LinkedIn crushed the estimates from both Wall Street and Estimize. Below is the reaction to the results.

So LinkedIn crushes expectations, it is growing extremely quickly, and the stock is up big the next day. And here's where you need to really pay attention to the action.

When a company like LinkedIn reports these kind of numbers, something special happens. The Fidelities, Vanguards, and BlackRocks of the world need to dramatically alter their allocation quickly. They don't care about paying up 20% to get the position they need to secure their spot in the story for a three- to five-year time frame. They are just looking for that tipping point when the story has been derisked to some extent, and they have a clearer view that LinkedIn will be a $50-$60 billion company one day. Because they need to pour in so much capital to move their needle, they don't really care about leaving footprints on the market and driving price.

So the most important thing you want to look for on the day of the gap is for this type of institutional participation. Are the big boys piling in? And it's not hard to see -- in fact, it's really easy to see. The first clue is simply: Did the stock close higher on the day than it opened? Very basic, were people buying up 20% or selling up 20%? If you have large institutions buying up 20%, it means they are positioning for way down the road and there is likely more size behind it, they will support the stock over the next few months on dips to get their position. They've made a calculated decision here, these guys are like cruise liners -- once they are headed in one direction, it's hard to turn them around quickly, but they leave the port really fast.

The next thing you want to look for is in the intraday tape. Were there big lots that went off at the ask? Again, institutions that don't care about covering their tracks by chopping their orders up into algos are the ones that don't care about driving price a percent or two, they are playing for the next 200%. If you see a lot of this, it's a great sign.

As you can see, this took place in LinkedIn, and the stock is did not give back that gap, it's now up over 80% from the open that day. Now let's take a look at the other side of the coin. A few days after LinkedIn reported its quarter, Michael Kors (KORS) reported its blowout numbers, as seen below.

So just like LinkedIn, Kors blows out both the EPS and Revenue estimates. But the action in the stock price post gap is very different.

Kors gaps up big and sells off all day. Institutions look at the price and aren't willing to bet that paying up is worth the ability to establish new positions. This can happen for several reasons. Maybe the big players already had their position and didn't need to pile in. Maybe they felt that the company wasn't going to scale so quickly that they wouldn't get another shot to buy it a big cheaper. Maybe they felt the quarter was an aberration and that growth wasn't going to continue at that scale, or that margins weren't going to be as good.

In any case, we don't really care why because the action in the stock price tells us everything we need to know. Institutions took advantage of the gap to sell part of their positions, and on high volume. You do not want to be buying stock at the close on this day if you are an intermediate or longer-term trader. I have looked at aggregate statistics regarding what happens to stocks that perform in this manner going out one to six months and it's not that pretty -- they normally close the gap, you normally get another shot to buy.

Now, by no means am I saying that Kors was not a strong stock or would not go on to far higher prices. It did, and it was one of my 10 picks this year and still is. Technical analysis does not tell us what stocks to buy or sell, but it gives us great clues and increases our odds of buying and selling, increasing or decreasing our position, at the right time. Pay attention to how stocks behave post gap and you will not only be able to spot potential big winners going out several years, but save yourself a ton of capital by not buying up 10%-20% in names where institutions are not pouring capital into the stock that day.

Simple, but very important, lesson.

Disclaimer: Nothing here should ever be considered to be advice, research or an invitation to buy or sell any securities, please see the disclaimer page for a full disclaimer.

Source: How To Play Post-Earnings Gaps In High-Growth Momentum Stocks