You’ve completed your analysis of a stock and you’re excitedly waiting for the day when earnings will be announced.
The reason why you’re excited is because your analysis shows that the company is highly likely to beat both its previous earnings forecast as well as the earnings forecasts made by analysts on Wall Street.
Soon the announcement arrives and it was in line with your analysis – the company beat earnings. You open up your brokerage account to check the price, fully expecting it to increase on this positive news.
Instead, the price dropped.
If you’ve ever found yourself in this situation it can be incredibly frustrating. After all it makes logical sense – if a stock beats earnings estimates shouldn’t the price go higher?
This article will explore some of the factors behind why this isn’t always the case so you can protect yourself from these types of scenarios.
Factor 1: It’s Already Priced In
There’s an age-old saying on Wall Street called “buy the rumour, sell the news.” It means exactly what it says – buy stocks based on rumours but once the news headline comes out, make sure you sell. Often, it’s probably even better to sell just before the news comes out.
The reason this saying generally works is because the expectations of a price move are already priced in by traders well before the news hits. Just like you, they may have conducted analysis that determined a company will beat earnings guidance and so traders start to buy in early.
As more traders come to believe earnings will be beat, they continue to buy more of the stock, pushing up the price. Once earnings are confirmed, expectations are changed for the next period.
Factor 2: Updated Guidance
Whenever an earnings announcement occurs, the company will generally provide guidance of its forecast earnings for the next period or more.
So, while a company may have had a good result leading up to the earnings announcement, it doesn’t necessarily mean that going forward after the announcement, they will forecast a good results. For example, gains may be as a result of a one-off tailwind that no longer exists.
Based on the updated guidance, market participants will adjust their exposure to a stock, which may mean selling it if forward guidance shows poor profits are likely.
Factor 3: Moving Onto The Next Opportunity
For traders, once they’ve entered a trade and it’s made them money, they’re generally looking for the next opportunity.
If traders are holding a stock that is expected to beat earnings estimates, they may sell it as the earnings announcement arrives with the expectation to move onto another stock, conducting the same analysis to find similar buying opportunities.
If they’ve sold their position and the stock pulls back far enough, they may even re-enter by ‘buying the dip.’ If the price doesn’t pull back enough, traders won’t be too fussed as they’ve already bagged profits and have freed up capital for the next opportunity.
Factor 4: Unwinding of Large Positions
There are a range of market participants from small retail investors through to large private investors, hedge funds, pension funds and even sovereign wealth funds.
These larger investors typically have huge amounts of capital so when they invest in a stock and want to unwind their position, they may actually cause prices to drop (due to the high amount of stock they are supplying).
To limit any drops, some large investors will sell into good announcements as these events attract a lot of buyers (and therefore demand for a stock). With enough buyers available, price falls can be limited.
Factor 5: Increased Supply
With traders taking “buy the rumour, sell the news” profits while large investors use the good news to unwind their position, there can be a lot of unusual supply hitting the market at once.
Sometimes this supply overwhelms the available buyers and prices fall. Depending on how much supply comes online at once, you can have very sharp drops after a positive earnings announcement.
Factor 6: Technical Traders
The final factor behind why stock prices may fall even after beating earnings is due to technical traders. Sometimes referred to as “noise traders,” these traders are on the hunt for signals that a stock is behaving in a way that can be exploited in the short term.
Technical traders don’t look at fundamentals, they care about elements of price action. For example, if factor 5: increased supply was in play, technical traders may notice the spike in supply occurring by monitoring the volume of bids and asks and comparing it to historic norms.
When they spot an oversupply hitting the market at once, they may jump on the opportunity by shorting the stock, thereby exacerbating the fall and making the price drop further than it normally would have.
Conclusion
Despite a company reporting positive earnings, there is every possibility that the price will immediately drop.
There are six key factors to consider around how a stock price might behave after an earnings announcement. Traders should understand that:
- The earnings surprise may already be priced in
- Updated guidance may point to poor results in the next period
- Some traders will be taking profits to move onto the next opportunity
- Large position holders may use the announcement as an opportunity to unwind their position
- Supply can spike, pushing down prices
- Technical traders may exacerbate moves
By understanding the key factors in play behind why this may occur, traders can protect themselves by either going risk-off (i.e. selling before risk factors are likely to turn into actual events) or by participating in the factors themselves (e.g. shorting a stock after unusual supply like a technical trader might).
Trade Safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
