3 secrets to trading ahead of earnings

Use these tools to trade stocks of companies set to report quarterly results.

By Jamie Dlugosch Jul 1, 2011 12:05PM

With the second quarter now finished, I'm gearing up for earnings season. While some folks shy away from trading stocks of companies set to release operating results, I use the opportunity to attack the market at its weakest and most inefficient point.

 

When a company reports results, the news will be greeted by overzealous buying or fearful selling almost immediately. The mad rush of buyers or sellers results in a stock that can move 5% to 10% higher or lower, depending on the company's success or failure at meeting Wall Street's expectations.

 

The beat-the-numbers game is alive and well. If you trade wisely, big profits can be had in a short period. The trick, of course, is to understand what is coming and position yourself accordingly.

 

I use several very effective tools to help guide my way to trading earnings successfully. On Monday, I gave a preview on 5 companies reporting earnings this week using these keys.

 

The results were spectacular but not surprising. Four of the picks moved exactly as expected with two picks, KB Home (KBH) and Apollo Group (APOL) generating more than 5% immediately after releasing results.

 

These trades are meant to be fast and furious. You do your analysis, make your trade and get out after the news and market impact have occurred. It is an aggressive and risky approach meant for a small portion of your portfolio, but quite lucrative when you are right.

 

Read below the video for 3 steps you can use to help you trade earnings:

Current stock price

 

It may be surprising, but the current stock price of a company about to report earnings can provide traders clues with respect to future action. Has the stock been running up in advance of the report? Where is the stock trading versus the rest of the market? Has the company released guidance in advance of the earnings report? What other news out there is impacting current stock price?

 

The answer to these questions will give you clues as to the future. There is a tendency for stocks to trade in a narrow range before earnings are released. Nobody wants to be on the wrong side of a trade and therefore volatility is limited. If that happens when stocks in general are moving higher, there is the potential for gains. If your analysis suggests that an earnings beat will be forthcoming you have the ingredients for a winning trade.

 

The short term price history of a stock about to report earnings is the first step to profiting from this sort of trading.

 

Wall Street Estimates

 

The beat the number game on Wall Street is alive and well. For whatever reason there is a strong reaction by investors after a company reports results. Temporarily there is an influx of buyers and sellers. The matching thereof is what determines price instead of things like valuation.

 

When supply and demand are out of whack you get volatility. It is that volatility however short term in nature that creates opportunity for those trading stocks in advance of earnings. Make the right trade and big bucks can be made.

 

The first place to look with respect to earnings predictor trading is to examine changes in estimates during the quarter in question. Compare those changes to actual events to determine if Wall Street is on the mark.

 

Typically analysts are slow to change their estimates. If there has been any sort of news on a macro or micro level traders can duly note such news. If the estimate has failed to move on the news, an opportunity is created.

 

I also like to use the business cycle in relation to Wall Street estimates. In the early going of a new cycle, estimates are often too low. The same is true at the end of a cycle when estimates are to optimistic.

 

Again, the idea here is that using Wall Street estimates to determine pricing in the market is inefficient. Traders can take advantage of that inefficiency by trading in advance of results.

 

Current valuation

 

At the end of the day valuation does indeed matter. Specifically, I love to trade stocks that trade for low valuations in relation to expected profit growth. If earnings results are better than expected these low valuation stocks can rocket higher after an earnings report.

 

Ironically, I do use Wall Street estimates here to determine valuation. The most promising stocks tend to trade for low multiples of earnings with those earnings set to grow at a rate higher than the multiple. It is not failsafe, but in most cases investors will make money owning stocks with such a metric.

 

On the flip side stocks that are richly priced must keep beating estimates to keep the momentum going. An earnings miss in such circumstances can send a stock significantly lower. Valuation is one of the best ways to find stocks that will win or lose during earnings season.

 

If you are interested in learning more about trading earnings, I am inviting a few close friends and followers of my work to receive my picks during the forthcoming earnings season. Please drop me an e-mail at jdlugosch@gmail.com. I will give you details on how to get my picks in advance of earnings and answer any questions you may have.

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