Earnings season always produces some great opportunities, but finding the best method to capitalize isn't always easy.
A large majority of companies will surpass their earnings estimates. At least 80% of stocks will surprise to the upside, but that doesn't mean you can just throw money at a stock and reap a profit when it posts a better-than-expected report.
Understanding expectations is the key to betting on earnings reports, but in many situations, you are better off trading a stock after the earnings news is released. You don't have to bet on the outcome of a report to reap a big gain. Good news is not instantaneously discounted. It takes a while for the market to fully appreciate a strong earnings report -- and therein lies the big opportunities.
Typically, analysts raise earnings estimates incrementally. They want to be conservative and raise estimates gradually, as it allows their clients to buy a stock more easily.
Also, a good report often means there is operational momentum, and a big beat now means better beats in the future -- and that will increased both estimates and P/E ratios. It takes a while for the market to figure out new valuations when conditions are shifting.
The big danger in earnings season is the "sell the news" reaction. Whenever expects estimates to be surpassed there is often an inclination to sell into the report and take the quick gain. Every earnings seasons has certain tendencies and in some quarters the 'sell the news' reaction is much more likely than others.
When Steve Jobs ran Apple, Inc (AAPL) , the company was notorious for low-balling guidance. Everyone knew that they would wallop the estimates, but the challenge was figuring out what the "whisper number" really was. That is often rather murky, but Action Alerts PLUS holding AAPL would normally beat by enough that there wasn't any real question whether they would.
There are few companies that perform like AAPL when it was in its hypergrowth phase, but there are some that do regularly surpass estimates by a sizable amount. The key to playing those is the chart setup going into the news. Risks rise fast when everyone expects a big beat.
An interesting example right now is Netflix, Inc (NFLX) , which reports next week. The stock is breaking out to new all-time highs and at least four analysts have raised their price targets in the last few days. The targets aren't huge jumps, but it shows that expectations are quite high -- and if there isn't a stellar report, there is going to be disappointment.
Jim Cramer weighs in on Netflix.
One of the most important things to keep in mind in earnings season is that charts do not tend to be good predictors of earnings outcomes. Many technical traders refuse to hold positions into earnings news because they consider it a coin toss.
Market players like to think that they have some special insight into earning but that is usually just wishful thinking. They will be lucky enough that they will confuse it with skill but a straight bet on an earnings report usually just a coin toss.
Some of my best trades have come when I buy after an earnings report. The big risk has been removed and the market usually takes some time to figure out a revised valuation. I like to take a small initial position on a good report and then average in as it develops further.
A good recent example of this is a stock I've mentioned quite often -- The Trade Desk (TTD) . The last two reports have been very good, but the reaction has been slow. There has been plenty of opportunity to build a position as the market comes to understand the valuation. On Friday, the stock was given a new target of $78 by an analyst that expects another good report.
Earnings season always offers some great opportunities, but the right strategy is key. It is far more complicated than betting on whether a company beats estimates or not.
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