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How I Like To Play Earnings

|Includes:Consumer Portfolio Services, Inc. (CPSS), PFMT, PSIX

Have you ever heard someone say "I don't like to play earnings."? I agree with where they're coming from. If you buy a stock on Thursday that reports Thursday night or Friday morning, it could open down 10% or worse. That's a lot of risk. A much less risky way to play earnings, is to see what the earnings are first, and buy after the open with a stop that lets you limit your losses. A lot of people have asked me to describe my methods around this type of play, so I'll describe the details here.

Finding the Companies to Play

What you're looking for are the overlooked companies while all eyes are on the bigger names that day. I'll use Friday, August 9th, 2013, as my example. You'll want to implement this on a day with more than 20 companies reporting earnings, so mostly during "earnings season" each quarter. First, read through Seeking Alpha's Market Currents Friday morning. Ignore any companies that missed on EPS or revenues or both. For companies that beat on both, look for the companies that beat on revenues by more than 10% or close to it. EPS can be inflated by buybacks, one-time benefits, and creative accounting gimmicks, but sales are sales. Consumers either bought a company's products and services, or they didn't. In recent quarters, a lot more companies have beat on EPS than on revenues, and even fewer beat revenue estimates by a large amount. The companies that reported Thursday night sometimes work too, but don't work as well for reasons that I'll explain below. You'll mainly want to target companies that are not trading in the pre-market. This play can work with companies that have traded that day in the pre-market, but it doesn't work as well.

Setting Your Opening Bid

The starting point for your opening bid will be 1% higher than the prior day's close. This can be adjusted higher for several reasons. First, I'll put the bid a little over the prior day's high if that's higher than my 1% starting point, but no more than 3% over the prior day's close. This is because you're trying to snag sell orders that were left open from the previous day. Second, you want to look at the pre-market bid. If that's higher than your 1% starting point, you may want to move up your bid to just above the pre-market bid, but again, no more than 3% over the prior day's close. Third, if the company absolutely blew away estimates by an astounding amount, or if the company is more well-known, you may want to start your bid at 2% or 3% over the prior day's close. You are not attempting to buy the stock in the pre-market, but you are placing your order before the open so that it is live at the open.

Researching the Company

This step will determine how large a position you want to play each company with, or which company to play if you've identified more companies than you're willing or able to play. First, take a look at the recent price action. Companies that have run up into earnings may have been expecting a beat. Companies that didn't run up into earnings will work more often, and for larger gains. Second, take a look at the short interest. I use Key Statistics on Yahoo Finance for this. The higher the short interest, the better this play will work, in most cases, as the beat could trigger a short squeeze. Third, and this is the most important step, scan the recent headlines on both Yahoo Finance and Seeking Alpha's Market Currents. You are looking for any recent bad news that could outweigh the beat's good news. Examples could be a CEO resignation, a recent acquisition that could require a secondary offering, a credit downgrade, or anything that could suggest that stockholders are looking to get out on the next jump. If you find a red flag like this, cross the company off of your list. I also tend to ignore MLPs, as they tend to not react as much to quarterly earnings reports.

You may have noticed that a proper due diligence was not part of this exercise. That could be a controversial point to some people, and a deal-breaker for others. In performing this play, you are assuming that good or bad findings in a proper due diligence are already priced into the stock price by the market. You are saying, all else equal, this new news is going to take the stock up. However, part of the reason this strategy works is that the news came out shortly before the market opened, and you are buying before all of the people who buy later in the day after doing their due diligence first. This is also the reason that companies that report Friday morning work better than those that report Thursday night.

Next Moves After the Open

First, if one of your bids fill, place a stop 2% below the price you paid. You can set whatever risk limit you want, or vary it by how volatile the stock is, but I have chosen 2%. Second, if a company is trading just above your bid for the first few minutes of trading, go ahead and move up your bid.

If you get stopped out, the play is over. Don't try to get back in. Some will dip and then take off again, but that action is outside of this strategy. If a stock gaps up more than 3% and stays up there, cancel your order. Some will gap up big and take off much higher, but those are also outside of this strategy. Be prepared for a lot of your bids to not fill, and some days where none of your bids fill. The reason this strategy works is because you are patient for the ones that start off slow and then make you a lot of money.

When to Sell

You are going to sell sometime the same day. If you hold past the close, you expose yourself to a gap down the next day far greater than your 2% stop loss. The safest strategy is to keep moving up your stop as the stock gains. However, this can lead to always selling 2% off the highs to that point of the day, which doesn't maximize gains. Also, how soon you choose to start moving up your stop can be a crucial decision. Moving it up quickly can limit gains in some cases and protect gains in others. I tend to move mine up slowly early in the day to give the stock a chance to run. Some traders will choose to try to sell a peak at some point of the day to get a little more, although that can lead to selling too early. It is a trade-off that is left up to each trader.

Returns

I have had great success with this strategy. I've also had countless near-misses where my bid didn't quite fill and the stock took off. The great thing about this strategy is that you don't even need a 50% success rate for it to be profitable. Even if you lost 2% on 2/3 of your attempts, if you averaged over 4% on your gains on the other 1/3, you would make money. I suggest paper-trading the strategy first to hone your skills before playing for real money.

Real Examples From Friday, August 9th, 2013

The first example is Power Solutions International (NASDAQ:PSIX). PSIX reported a revenue beat of $5.2M over an estimate of $53.9M. I'd call this close enough to 10%. EPS beat an estimate of $0.21 by $0.02. The stock closed the prior day at $46.39. An opening bid 1% higher would have been $46.85. The stock did not trade higher than $46.85 the prior day, nor was it a beat by an astounding amount, so I would not have adjusted the bid up from there. The stock had not run up by a large amount into earnings, nor did I see any red flags, so it was in play. The bid would have filled at the open for $46.00. If it didn't, the stock still traded around $46.97 for about 15 minutes, so I would have moved up my bid to that level if needed (only 0.25% higher). If you filled at $46.00, your stop would be placed at $45.08. Less than an hour later, the stock was at $50 (up 8.7%). Your stop would have moved up to $49, and an hour later you would have stopped out for a 6.5% gain.

The second example is Performant Financial (NASDAQ:PFMT). PFMT reported a revenue beat of $7.2M over an estimate of $62M, more than 10%. EPS beat an estimate of $0.21 by $0.02. The stock closed the prior day at $11.07. An opening bid 1% higher would have been $11.18. The stock did trade a little bit higher the day before, up to $11.18, so I would have adjusted the bid up by five or ten cents, let's say $11.28 (less than 1% more). The stock had not run up by a large amount into earnings, nor did I see any red flags, so it was in play. The bid would have filled five minutes into trading for $11.20, although if you were trying to buy more than $8,000 worth, you may have only received a partial fill. Your stop would be placed at $10.98. Ten minutes later, the stock was at $11.66, and if you're really fast at moving your stops by the minute, you might have been stopped out as it dipped back to $11.43 about 15 minutes later for a 2% gain. Personally, I don't move my stops that fast. I'm watching a lot of stocks each day, and I like to give these room to run, and $11.66 wasn't that big of a jump, so I wouldn't have moved it up yet. Your stops are trying to limit your losses; protecting gains is a secondary priority. Four hours later, the stock was at $12 and stayed there a while. I would have moved my stop up by this point, eventually settling into $11.76. It never dipped back to that point, so I would have sold near the end of the day around $11.85 for a 5.8% gain.

The third example is Consumer Portfolio Services (NASDAQ:CPSS). CPSS reported a revenue beat of $33M over an estimate of $37M, more than 90%. EPS beat an estimate of $0.14 by $0.01. The stock closed the prior day at $6.42. An opening bid 1% higher would have been $6.48. The stock did trade a little bit higher the day before, up to $6.56, plus I would consider this an astounding beat, so I would have adjusted the bid up the full 3% max to $6.61. The stock had not run up by a large amount into earnings, nor did I see any red flags, so it was in play. The bid would have filled at the open for $6.59. Your stop would be placed at $6.46. Again, if you were really fast at moving your stops by the minute, you might have been stopped out as it dipped from $7.08 back to $6.94 about 20 minutes later for a 5.3% gain (not bad). If you hadn't moved it up yet, the stock moved up to $7.23 an hour later and you may have been stopped out from there a while later at $7.09 for a 7.6% gain. Either way, a nice gain.

Another example that fits our strategy from Friday morning is Tremor Video (NYSE:TRMR). Our bid would not have filled however, as it gapped up 12% at the open. It's a good thing our strategy tells us not to chase these gap-ups, as 40 minutes later the stock had given back the entire opening gain.

Closing Thoughts

First of all, this is a day-trading strategy, not an investment strategy. Second, Friday was a day where this strategy worked really well. It doesn't always work this well, but it has been a winning strategy for me over a long period of time. Try paper trading it first, try adjusting your stop loss limits, or your max bid amount to catch a few more 4% or 5% gap-ups, see what types or sizes of companies it works best with, and you might come up with an even better set of rules.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Stocks: CPSS, PFMT, PSIX