Today's Trading Lesson From TradingMarkets

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How To Use TM's Indicators: Stocks That Rose On Worse Than Expected Earnings
By Daniel Beighley

If good news sends a stock down, what's going to send it up? The focus of this lesson is a little gem on TradingMarket's "Stock Indicators" page under "Actionable Signals & Other Indicators": Stocks That Rose On Worse Than Expected Earnings, and Stocks That Dropped On Better Than Expected Earnings. Simply put, these alerts give setups with good risk/reward characteristics.

Earnings are the underlying force of stock valuations, and nothing will change the direction of a stock faster than earnings-related news.  Surprises in earnings reports almost never fail to make or break price action, and many traders won’t even take a position in a stock the day of an earnings announcement because it might drastically alter its trend. On the other hand, when alerted to price action divergence from earnings news, the astute trader can take advantage of certain situations.

A stock that rises on worse than expected earnings, or falls on a better than expected earnings, is telling you something is out of place. Whether it be institutional interest or a  less obvious agent, is not so much an issue as the fact that the stock traded against the news.  When analyzed in conjunction with technical analysis, this divergence has the makings of a profitable setup for a swing trade, or even a longer-term trend reversal.

When it comes to interpreting market news for the sake of profiting, many of us have experienced the madness that comes from illogical price swings, and seemingly irrational behavior. As Larry Connors elucidates in Street Smarts, we need to listen to what the markets are telling us.  A stock that rises on better than expected earnings is saying, "This may be bad news, but I don't care!" Just because it seems natural for a stock to rise on good news in no way means that this will happen. The reverse is true of a stock that falls on good news. The price action is what we should focus on.

Below are four recent examples of stocks that acted counter to what their earnings announcements suggested. As one might expect, these alerts can be few and far between, and in keeping with reality, one of the examples illustrates a setup that didn't  work out. Nothing is ever a sure thing in the markets, though what we aim for is at least a good risk-to-reward ratio.
 

Example 1: Research in Motion (RIMM)

In our first example, we have Research In Motion (RIMM) announcing earnings of 8 cents a share, worse than analysts had expected. As you can see, the stock didn't seem to mind, and began an uptrend stemming from that news event. Combining a little bit of bar chart analysis with this news could have comfortably positioned a trader in this stock for a nice gain. The day the news was released, a trend reversal in the daily bars set up, as the price action moved higher than the previous two trading days ranges. If you were to have went long the day after the report, at least a 2 point gain would have been made in six trading days. A stop loss should have been placed above the high of the daily bar of the news release.
 

Example 2: Shuffle Master (SHFL)

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Here is an example of an alert that didn't work out. When Shuffle Master announced earnings of 63 cents a share, worse than analysts had expected, the stock initially rose. Unfortunately it did not make a trend reversal, and a long position off the alert would have been a loser. The next two days of trading, despite some upward momentum, produced tails on the daily bars, giving warning of some weakness in the stock. If you were to have used a stop loss below the low of the day the news event was triggered, you would have been out with minimal damage. Using technical analysis to aid in your decisions is definitely an advantage. Some traders may have avoided the setup as the gap down was a sign of weakness, though even the best of us put on losing trades.  The intention of this example is to educate.
 

Example 3: Apollo Group (APOL)

APOL announced earnings of 27 cents a share, beating analysts' expectations by a penny. The initial reaction to the news sent the stock down. An astute trader may have taken the opportunity to short the stock as its daily bars were also suggesting some downside momentum. Note the ominous tail leading into the news day's expanded trend reversal bar. An short entry  on the day after the news release would have made at least 3 points in nine trading days.  A stop loss, placed just above the bar of the news release day, would not have been triggered.
 

Example 4: Solectron (SLR)

SLR announced earnings of 8 cents a share, beating analysts expectations of 5 cents a share. From looking at the chart, we can see the stock gapped down the day before the news release, giving an indication of weakness. An entry on the short side the day after the earnings report would have quickly turned into a winner.  A stop loss should have been placed above the high of the daily bar of the news release. In this situation scaling out of the position would be a great way to take some profits. For some great swing trading and money management strategies take a look at Dave Landry on Swing Trading. 

Trading against the logic of a news event is something many traders are uncomfortable with. When analyzing news events, we need to keep in perspective "what is," instead of "what should be." Getting caught in the emotions of news stories can often spell trouble for traders, but with the right mind-set these events can be profitable. The earnings alerts on TM's "Indicators" page, should be viewed as invitations from a stock to act counter-intuitively, and avoid some of the common pitfalls that "the herd" mentality will get a trader in. What seems like stepping in front of a train could be your next ticket to a winning trade.

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