You've probably heard about the incredible money that can be made trading earnings announcements. But the truth is that you can also lose a lot if you don't do it the right way. In fact, a lot of people who trade earnings announcements have the wrong idea about it.
For example, a lot of people will buy shares of a popular growth stock right before earnings. Like Netflix, for example. They might wait around and then buy Netflix stock right before earnings, believing that it's earnings growth will be high.
But the problem with this strategy is that the market might already have priced in the expectation of high earnings for Netflix. Even worse, earnings may have grown slower than the market expects.
You really have no idea what earnings are going to be until they actually come out.
So how can you trade earnings if you don't know what they are going to be?
According to the dominant academic theory of stock pricing, the market is “efficient”. The only reason that a stock is underpriced or overpriced is because investors do not yet know what price it should be.
This theory implies that once an earnings announcement brings a surprise, the market should change immediately to reflect the new information.
If this is true, it means that the only way to profit from an earnings announcement is to buy the stock ahead of time.
However, there is a rival theory that has a lot of evidence to support it. It's called Post-Earnings-Announcement Drift or PEAD. It's also sometimes called the “SUE effect”.
According to this theory, stocks do not automatically adjust to an earnings surprise. Instead, it takes up to sixty days for a stock's price to absorb the information contained in an earnings report.
If you're an accounting geek and want to know the evidence for this theory, you can read all about it here.
Otherwise, let me show you how you can use this theory to profit from earnings announcements.
Take a look at this chart of Twitter.
See the big gap up on April 26? That's the day of Twitter's earnings report. In this report, it was discovered that Twitter added 9 million monthly active users in the first quarter of 2017.
Now, if you had somehow bought the stock before the announcement, you would have made a killing. But there's no way you could have known this would happen without having inside information.
However, notice how the stock gapped up on the first day, then went up even more throughout the rest of the day, and then closed almost back to where it was before?
And notice how it went back up again the next day?
Even if you had waited until the first daily candle closed, you still would have made a nice profit by the end of the second day.
In fact, a stock that has an earnings surprise like this will usually rise for weeks.
So all you have to do to play an earnings report is to wait and see how the market reacts to the report. If it has a huge rally and closes much higher at the end of the day, then you can get into the trade.
A lot of people don't trade earnings calls the right way. But use PEAD to your advantage and you should do better than most.