Why Stock Prices Fall After Good Earnings Announcements
Recommended strategy which capitalizes on good (and bad) news: Ten Steps To Profitable Trading.
It’s happened to all of us before, at least those who trade the markets on a regular basis. You hear on the news that such-and-such a stock has released an earnings announcement and the company has ‘beat analysts expectations’. The announcements usually come out after the market closes.
What do you do?
If you use a broker then you call your broker and tell him to buy the stock as soon as the market opens the next day. If you trade for yourself then you make your order to buy at market open.
The market opens and the stock is already up several points. You buy as soon as possible and watch excitedly as the stock price continues to rise giving you some immediate gains. Then, about 30 minutes after open the buying activity starts to slow and the stock price takes a turn downward.
Unfortunately it doesn’t stop there. In fact the stock continues down below the opening price, and aside from one or two minor bounces, it keeps falling and closes for the day well below the price it opened the day at.
If that wasn’t enough already, over the next few weeks the stock continues downwards until eventually you, and others like you, throw in the towel, exit the stock with yet another loss to add to your portfolio of consistent losses. Another mistake you keep to yourself.
So what happened?
The company announced better-than-expected earnings yet the stock price dropped soon after. Surely this is counter intuitive.
To rub salt into your wounds, you hear the news on the TV or the internet and they tell you that the price fell after ‘profit taking’. What profit taking? No one had a chance to profit-take as the price fell almost immediately.
To get to the bottom of the problem we need to take a few steps back. If we look at what happened from another angle, then it’s easy to understand, and if we’re smart then we can take advantage of the mechanics of it in our next trade. This is covered in more detail in the ‘Stock Trading Nitty Gritty‘ trading course by Bill Poulos.
Who made the money?
Those who ‘took profits’ at the time of the announcement were the ones who obviously made money at the expense of those who rushed to buy when the news came out. One type is known as the smart money, the other is known as the dumb money.
This is what happens. Just before market opening there is a backlog of buy orders waiting to be filled. After a mention on the morning news and a positive analyst statement the volume of orders skyrockets.
As a result of the news and hype, the stock price opens much, much higher than the previous night’s close. A serious ‘gap-up’.
Moreover, additional orders which come during and after trading begins push the price up further still, and this price ‘levitation’ usually continues upwards for about 30 minutes.
This is a classic buying ‘frenzy’ which accompanies each and every better-than-expected earnings announcement to a more or lesser degree. The only thing stopping the price from actually going through the roof is the almost equal number of people selling their shares into this buying pressure.
These are the people making the real money – the smart money.
Within about 30 minutes of market opening all of the panic buy orders have been filled and the price has spiraled out of all proportion. The sellers are still lined up in droves (at this price very few wouldn’t sell) but the buyers have all but evaporated. No one else is prepared to buy at this price, or anything close to it either.
With lots of sellers and less and less buyers the stock price starts to fall, and fall quickly it does. From there the stock price continues to drift downwards over the next few months and the cycle starts all over again.
How you can take advantage of this situation?
You need to join the ‘cycle’ at a different time. Instead of joining it at the top, join it at the bottom, or better still just after its reached the bottom and is now on its way back up again.
Here’s how you do that
Firstly find a company which has shown consistent growth over the last three or four quarters. Ideally this would be one which has met or exceeded analysts expectations at every quarterly announcement. There are plenty of them, even in a falling market.
If you look at the stock chart you would look for a pattern which showed the stock price rising quickly in the four to six weeks ahead of each earnings announcement, only to drift down again afterwards. Not all the way down, as it’s better to target a stock whose overall trend is up (higher highs, higher lows).
The trick is to take your position about four weeks ahead of the earnings announcement. This would be about the time the first of the smart money does. As more of the ‘smart money’ joins you the price starts to rise.
This acceleration of the price rise attracts more buyers, which in turn causes the price to rise more quickly, which in turn attracts even more buyers. Nice.
On the day of the earnings announcement when the news comes out be ready to sell to the buyers who rush to buy. Do this about quarter to half an hour into the trading day. If there’s a lot of hype and coverage going on as well then you could see several more points added to the price.
Take it from me, selling to the buying frenzy on earnings day is a feeling like no other.
There’s a great little strategy you can learn if you’re new to trading and want to avoid the pitfalls almost all other novice traders make, you should take a look at the Ten Steps To Profitable Trading.
It works by trading on pullbacks, thereby keeping you from buying in at the wrong time. Remember buying in at the right time in the cycle? It will take you through a similar but way more powerful trading strategy that will have you selling into the hungry buyers time and time again. I recommend you take a look.