Trading Stocks Over Earnings

• Posted by Joe Fahmy
• on October 18th, 2009

For current trading ideas, see my Market Notes from 10/15/09 (click here).

In Jack Schwager’s Market Wizards, one of my favorite interviews is with Paul Tudor Jones. I highly recommend reading it because Jones has all the qualities of a successful trader: confidence, flexibility, intensity, emotional control, lack of ego, ability to cut losses, and consistent returns with minimal draw-downs. Jones believes the most important rule in trading is: “Play great defense, not great offense.”

I especially think of this quote when trading stocks over earnings reports. Jones says “never trade in situations where you don’t have control. For example, I don’t risk significant amounts of money in front of key reports, since that is gambling, not trading.” Although Jones was mainly referring to his futures positions, this advice can also be applied to stocks or any other trading instruments. (This strategy does not really apply to long-term investors who are holding positions over several quarters of earnings or longer).

Since we are currently in the midst of earnings season, I want to discuss a strategy that I find fairly successful when trading stocks around news releases. It involves “buying the rumor and selling the news.” In other words, I find that many stocks “run” into their earnings dates and tend to “selloff” after the release, especially if the stock has run nicely in anticipation of the news. Therefore, part of my research during earnings season is to find out EXACT earnings dates and to try and take advantage of possible moves prior to those dates.

For example, last quarter I traded $GMCR in mid-July (near $60) and sold it (near $70) as it ran into its earnings at the end of July. I did not hold a position over earnings because I realize that some of the stocks I trade are “priced for perfection.” In other words, the downside of potentially disappointing news far outweighs any upside earnings surprise. This strategy worked as $GMCR beat their earnings, raised guidance, but slightly missed on revenues causing the stock to gap down -8% that morning.

One thing to keep in mind is that I am not blindly buying stocks a week or two prior to earnings. My strategy begins with sound fundamental companies and combines buying them near strong technical areas. For example, I recently purchased a position in $GMCR with the same game plan heading into its earnings in early November. I am looking for the stock to run 10-15% (from approximately 72 to 82) prior to their announcement. However, I will maintain a stop near the 68 area of support in case I am wrong.

Other examples of recent earnings trades were $RIMM and $GS. Both of these stocks gained approximately 10% in the 2-3 weeks prior to their earnings. In GS’s case, they beat and traded lower, and in RIMM’s case, they missed and traded lower. Of course not all companies trade lower after their earnings; however, I am more concerned with “playing defense” rather than missing potential upside, especially if the company has already made decent gains ahead of the news. Another example is $DNDN. I played the stock from $24 to $30 ahead of its Analyst Day on 9/24. Although this was not an “earnings release,” it was still a situation where you could “buy the rumor and sell the news” prior to a key report. In DNDN’s case, the stock sold off when no partnership news was announced at their meeting.

There are situations where I will hold a stock over earnings. For example, I like to find “sleeper” companies that are not widely followed by analysts. In other words, I would never play $MSFT over their earnings because 400 analysts follow them and their estimates are in a fairly tight range. I usually look for companies that have a few analysts covering them, thus making upside surprises more likely. One VERY important note: when I do trade stocks over earnings, I hold a "smaller than normal” position size. Again, just "playing defense" rather than worrying about missing some upside. If you are adamant about holding a stock over earnings because you have done your research and you are 100% convinced that they will beat estimates, my best advice would be to hold a position that will allow you to "sleep at night" in case the stock gaps down 10-20%.

In summary: do your due diligence, find out the earnings dates of the stocks you are trading, try and take advantage of “run-ups” into earnings, and if you decide to hold over earnings, keep your position sizes small. Remember: “PLAY DEFENSE!”

Follow me on Twitter @jfahmy

Tickers: DNDN, GMCR, GS, Jack Schwager, Market Wizards, MSFT, Paul Tudor Jones, RIMM

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