Monday, September 18, 2006

A Focus On Earnings

Though I consider myself a technical trader, I don't deny the power of fundamentals. From the viewpoint of an investor as opposed to that of a trader, fundamentals can be considered to be critical in the determination of "what" to buy. Of the many fundamentals to analyze, I believe that earnings may be the most important. The old saw "follow earnings, follow earnings, follow earnings" is fraught with wisdom. Earnings say a great deal about the health of a company. I look for increased earnings year over year and quarter over quarter. In fact, I regularly use a scan I created that incorporates increased earnings year over year and quarter over quarter along with a requirement that the company be in an upper percentile of all companies as far as earnings go. (In that scan, I also include other criteria such as minimum average volume, debt, P/E, etc.) If I can find companies that are steadily top earners and also are increasing earnings, I am confident that I have found strength and that strength could translate into increased stock prices in the future.

The $64 question is "when" will the stock price increase and fundamentals rarely answer that question. Is there a right time to buy a stock? Though many say "you can't time the market" there are some methods to enter that I think give the trader a better chance of success. I've always taught that a trader should make his exit "close and clear." By that, I mean that when a trader enters a position, he *should have pre-defined his exit* and that exit should be fairly close to his entry. Some teach that one should exit whenever the position drops 8% or 10% or 15%; others teach that the break of a line on a chart such as a moving average or a trend line should serve as an exit. I prefer the latter, but the most important point is that the trader should have (must have) a predetermined exit in the event the position turns against him. If I use a bounce off the 25 day moving average as my entry, then a close below that same line at least would be my initial exit. If the stock bounced up and I bought, then I would sell when the stock went below the line. As the stock goes up, line goes up, but if the stock turns down, then I would get out. That's a way to determine the "when" of getting into a position.

As you can see, I now have a way of finding both a "what" and a "when" to trade. However, I started by talking about earnings. Undoubtedly, longer term, earnings can guide the movement of a stock's price. What about short term? It's interesting to me that many times a stock will announce pretty decent earnings and right away the price drops. Have you seen that happen? Why? How does that make sense? Well, first of all, I don't think the market necessarily makes sense -- especially in the shorter run, but seriously, I believe the time around earnings announcements is a time for cautious trading. I think the price of a stock often drops when earnings are announced (even if they're pretty good) because of the old adage "buy on the rumor, sell on the news." The earnings announcement is the news. All of the anticipation and excitement are gone when the announcement is made. The excitement and anticipation occurred before the earnings were announced. Notice how often there is significant movement in a stock price as the earnings announcement date approaches. There may be a big run up or down; the stock is often more volatile and so are the options.

I trade a fair amount of options and one of the methods I use is to trade volatility. I like to sell volatility when it is high (and overpriced) and buy when volatility is low (and underpriced). Many times, as the earnings announcement date approaches, volatility increases and may provide a time to sell options. After the announcement, volatility may sink providing a chance to buy. For the stock trader, there may be a buying opportunity as the stock begins to rise in anticipation of earnings, or there could be a possibility of a short sale if the stock begins to slide in anticipation of the announcement. In each of these scenarios, be aware that there will be a probable change when the earnings have been announced. If I am making a play coming into earnings, I will frequently exit before the actual announcement. I'm trying to "buy on the rumor, sell BEFORE the news."

Of course, there is no sure thing in the market. No one without insider information can tell for sure what direction a stock will take going into earnings and following the announcement. Though volatility many times can increase before the announcement and drop right after the announcement, it also can do exactly the reverse, or it can do nothing.

What does seem helpful is the knowledge that there is an impending event (i.e. the earnings announcement) and the fact that it is coming leads to excitement, anticipation, even apprehension. That knowledge can give the trader a little edge just by knowing the announcement is coming. The trader may tighten stops as the announcement approaches or he may exit a position shortly before the announcement, or he may place a "buy stop" in case there is a sharp move following the announcement.

All of this leads to the conclusion that anyone who is trading or investing in the stock and options markets should be aware of when a company is scheduled to announce earnings. You should be able to get this information from your broker.

Be aware, it's mid-April, the first quarter has ended and now is the peak season for announcements. At least check the date earnings are scheduled to be announced. The information may help your decision making process.

Bill Kraft, Editor
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