I’m a huge fan of the phrase: “Buy the rumor, sell the news.” When I first started trading in the mid-1990’s, I remember holding stocks that would make big moves ahead of their earnings reports, only to drop after the announcement. I thought to myself: “I don’t get it, they beat their earnings and gave strong guidance, why is it down?” I finally realized that Wall Street often likes to trade ahead of key events, and then selloff after the news or report comes out.
So, I decided to change my approach. My new strategy would be to trade stocks ahead of key events, take advantage of any run anticipating the “rumor,” and sell the stock PRIOR to the “news.” Key events include earnings releases, shareholder meetings, analyst meetings, user conferences, and sometimes even economic reports. This theory obviously doesn’t work all the time, but it works consistently enough that I have added it to my arsenal of trading strategies.
A real-time example of this happened over the past 4 trading days. I bought $NFLX last Tuesday morning (4/19/11) and sold it Monday afternoon (4/25/11) prior to its earnings release (after Monday’s close). I made approximately 20 points on the trade. Here are some keys to this strategy:
1) DO YOUR HOMEWORK. Find out the EXACT date of the earnings/event. That’s the easy part.
2) CHOOSE STOCKS that are liquid, widely followed, and preferably highly shorted. For example, stocks such as $AAPL $NFLX $PCLN tend to run ahead of earnings reports, and if it’s a highly-shorted stock such as $OPEN $LULU $DECK, the shorts tend to cover prior to earnings.
3) FIND A LOW-RISK ENTRY POINT for your trade. This isn’t so easy as it took me years of trading to work on getting better entry points. In general, it helps to trade around strong technical support areas.
4) HAVE A LOSS CUTTING STRATEGY. No matter what your reasoning is for making a trade, ALWAYS USE STOPS! For example, I got into $NFLX around 233, my stop loss was 228, and my target was 250-255 (a 4R trade). If the trade didn’t work, I wasn’t going to force it or be stubborn about it. I was simply going to sell the stock. As Paul Tudor Jones says: “Play great defense, not great offense.”
5) STICK TO YOUR PLAN AND DON’T GET MARRIED TO THE TRADE. Whether the stock hits your target, your stop, or somewhere in between, don’t risk holding over the event. Simply move on with no regrets. In other words, if $NFLX goes up 30 points after its earnings, I don’t care! Too many times, technical traders start reading fundamental news to justify why they should hold over earnings. JUST MOVE ON TO THE NEXT ONE WITH NO REGRETS AND NO EMOTIONS!
One final point: This is one of many strategies that I use to trade AHEAD of earnings. Sometimes, I will hold a position OVER earnings, but I will save that topic for a future blog post. Again, the above strategies don’t work all time, but they are consistent enough to consider using as a trader.