Anyone who ever attempted to trade during the earnings season is well aware of the fact that making money in this time period is highly challenging and illusive. This can be attributed to the following factors:
- Very often, companies report the exact opposite of what we predicted: A company which we were sure would miss its earnings target, somehow miraculously beaten its target by a vast margin, and vice versa. It is worthwhile mentioning that analysts are no better at predicting company's numbers than any other person, they consistently err in their estimates and even the ones who manage to provide a precise prediction do not seem to be able to perform this task consistently over a long period of time.
- Quarterly earnings are not necessarily what counts. Very often, investors carefully watch the future guidelines provided by management rather than the actual quarterly earnings. In other words, stronger emphasis is attributed to future earnings rather than to past earnings.
- Even when we are able to correctly predict the "direction" of the report (miss or beat) and even guess the ballpark of the number reported by the company, a profit on the trade is not guaranteed because one never really knows for certain what part of the information was already embedded in the stock price. Put it differently, if everyone and their brother believed that company X will report a quarterly loss of $3.5 per share, and the company ended up reporting a "minor" loss of $3.2, the stock could actually rally on the "good" news.
Therefore, the golden path to trading earnings is by NOT basing your trading decisions on illusive metrics like: past earnings, percentage surprise, "whisper numbers," analyst recommendations, put-call ratio or anything remotely similar.
The golden path to earnings is to only trade once the odds are in your favor. What I mean by that is to only trade companies which have a proven record of robust percentage change in stock price on the earnings day itself. Short those stocks on the day prior to their earnings report.
The following companies present to us some fine short candidates:
|Name||Price||P/E||Report Date||Positive % Report days||Average Report Day % Change|
|Atwood Oceanics (ATW)||$45||10.85||2/1/12||0%||-4.55%|
|InterMune Inc. (ITMN)||$14.36||8.9||2/16/12||0%||-4.84%|
|Eaton Vance Corp (EV)||$25.8||14.7||2/23/12||0%||-4.43%|
By the way, the fourth candidate on this list (that already reported earnings on January 18th) was Sealy (ZZ). As we know, ZZ dropped from $1.84 to $1.52 on the trading day following earnings, a drop of 17%.
I will issue timely updates on these shorts as we approach their respective earnings dates.