The Key To Huge Gains During Earnings Season Without Added Risk
StreetAuthority Network
Four times a year, companies report their financial results and investors score their performance in real time with real money. Those that impress can see shares soar, while those that disappoint may suffer losses and even gap down through investors' protective sell stops.
Bottom line: Earnings season is the most volatile scheduled time of the year for stocks -- and traders' portfolios.
As the chief investment strategist for Profitable Trading's Alpha Trader, it's my job to steer the ship for my subscribers. Today, I'm going to discuss my objectives for earnings season and how I manage entry risk for my readers, because many of these are ideas you can apply to your personal portfolio as well.
My primary objective is to conservatively manage the downside volatility or risk of new entries during earnings season. Paul Tudor Jones, one of the greatest hedge fund managers of all time, once said, "Risk control is the most important thing in trading." He has also said, "Don't focus on making money, focus on protecting what you have."
I first read those words in Jack Schwager's "Market Wizards" 20 years ago, and they've stuck with me ever since. They are especially apt during earnings season, as I prefer not to step in front of an earnings steamroller.
Below is a chart for Chipotle Mexican Grill (NYSE: CMG) that should serve as a cautionary tale for anyone who's thinking about buying into an earnings announcement.
Back in 2012, Chipotle was a clear example of a growth stock in a multiyear uptrend. Shares were up nearly 25% over the prior 12 months.
Going into the Q2 earnings season, analysts expected the company to report revenue of $705 million and earnings per share (EPS) of $2.30 -- and the market agreed, bidding shares up 7% in the weeks leading up to the announcement. After the market closed on July 19, 2012, the company reported EPS of $2.56 but revenue of just $691 million.
When the market opened the following day, shares were $75 lower, resulting in an instant loss of nearly 20% for any investor who had bought right before the release.
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Entering a new position just prior to earnings can expose you to this type of gap risk, and it's exactly why I prefer to wait until after the release to see the market's interpretation. It's certainly a more conservative tactic, but it's also one that protects me from these immediate losers.
Some of you might be wondering, "But won't you miss the ones that rocket higher?"
Sometimes. But I'm willing to make this important trade-off for three critical reasons:
1. Risk management -- I intend to protect what I have.
While it's impossible to avoid all losses, by not trading directly into earnings announcements I can minimize my exposure to high-risk, overnight events like we saw with CMG.
2. I can still catch big winning trends.
Let's say you follow my conservative approach and wait until after earnings are announced to move into a new stock. But this time, instead of avoiding a big gap down, you miss out on a major gap up like we see with Apple (NASDAQ: AAPL) below.
AAPL Stock Chart
When the market closed on Jan. 24, 2012, AAPL was trading for $56.65 (split adjusted). After an impressive first-quarter earnings beat, shares opened the next day at $61.24. That's an 8% move you could have caught right off the bat.
But here's why you shouldn't sweat it: Gaps up on strong earnings can be the start of large and persistent trends. They tell us the market is willing to pay "way up" to own the stock. Buying the right breakout after a large earnings gap higher -- especially out of a long-term base or trading range -- can end up sacrificing very little in the long term.
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Following its gap higher, AAPL surged 42% in just three months before moving into a holding pattern.
AAPL Stock Chart
While you would have missed the initial profit on the gap higher if you waited until after the release to buy, you still would have caught the major uptrend.
This doesn't mean all stocks that show initial gaps will automatically trend higher. Whether it's an issue with the stock itself or a symptom of the broader market running into trouble, some stocks that gap higher fail to trend, which is why I have exit rules in place for Alpha Trader to cut losses short.
The final reason I like to be conservative about earnings season is an emotional one.
3. While Alpha Trader is based on a defined quantitative system designed to spot stocks on the verge of a breakout, its subscribers are real people with real emotions and investment goals.
I respect this, and I have their back with a conservative approach to investing.
Losses are a normal part of investing, but buying right before earnings releases unnecessarily puts us in a position that could result in a string of big, gap-down losses.
No matter who you are, seeing a huge chunk of your money wiped out overnight is rough. Enough of these large losses in a row is emotionally untenable for most of us.
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Yet, you have to be willing to accept strings of losses to mechanically execute a system. You have to keep pulling the trigger and buying so you can eventually capture the big winners. Those big winning trends pay for normal losses that occur and are the key to generating large profits over time. This is the profitable essence behind following trends.
The concept is simple, but psychologically, it's very hard to do. The problem is when investors jump off the system. They become disheartened, think the system has failed and stop following buy signals. Then the next win streak occurs. But they fail to participate because they stopped following the system's rules.
My conservative path offers a more palatable investment ride over the long term. We will still take losses, but we will keep pulling the trigger and keep capturing big trends. By avoiding earnings catastrophes, I offer a smoother ride in the process, which I hope will keep investors from ever getting so discouraged that they throw in the towel.
While the Alpha Trader system won't pick winning trades every time -- no system can -- over the long term, it's been shown to be a winning system.
My latest recommendation is a small-cap company that recently gapped up 7% on an earnings blowout. The stock had moved mostly sideways since September before surging nearly 18% during the week of its earnings announcement on a huge increase in its 10-week average volume.
The vault upward broke it out of a five-month consolidation. I'm not worried about the gains I've missed so far, because I think it has the potential to double in the next 12 months.
