Sunday, May 11, 2008

How to Look for and Trade Earnings-Related Breakouts

Most would agree that the goal of any trader, regardless of philosophy or the markets he or she trades, is to make money, hopefully in a fast manner. There are many different schools of thought on the best way to do this - some are fundamentalists, some are technicians, some are value players, and some are day-traders. Although I consider myself a technician, I am always looking for ways to improve myself as a trader, and as such, I look for strategies that will help me make more money, hopefully in a shorter amount of time. One of the most valuable strategies I have found for this basic purpose is finding and buying earnings-related breakouts.

BOOM - 1100% move in a year and a half
I remember this breakout but had no clue back then
of how to trade this. I was scared to death to buy
a stock like this that was up 100% in a day.
Charts from Telechart2007, Courtesy of Worden Brothers, Inc.

To start, I want to point out that much of what I have learned about this strategy came from Pradeep Bonde's blog, Stockbee. I have posted the links below to his site that have helped me the most learn about and develop this strategy. I am still learning and trying to master this strategy, while he, due to his research, is much more accomplished with trading this strategy.

Since we are in the middle of earnings season, particularly the small-cap earnings season, I thought this would be a good time to discuss this strategy. The basic idea is this: find companies that post tremendous earnings, get into these companies as soon as possible, and ride the momentum upward until certain technical signals tell you the party may be over. I'll break these three parts down now.

Part One - Find Companies that Post Tremendous Earnings

The first question you should ask is, "what qualify as tremendous earnings?" It really depends on who you ask. IBD recommends looking for stocks that show earnings and sales growth of at least 25%. This is fine, but there are a lot of companies that achieve this level of growth. You are really looking for the best of the best. It's pretty simple - the higher the growth, the higher the stock is likely to go. I would pick some minimum cutoffs and stick with them. Quarterly earnings that are up 50% year over year are great, and is the minimum amount I would start with, although I really want to see growth over 100% or more. You also want to look at quarterly sales growth year over year, although this usually isn't quite as high as the earnings growth. Perhaps 20-25% is a good minimum to demand. As always, however, the higher the better.

Even with those standards, you will still find many companies and often times need to decide if a stock is worth entering. The next thing to look for is the float of the company. Pretty basic idea here - the lower the float, the faster the stock will move. Isaac Newton's second law of motion states that the smaller an object is, the faster it will be able to accelerate with a constant force. It's the same principle with stocks. If a big-cap company with hundreds of millions of shares outstanding posts quarterly earnings and sales growth of 50-100%, it probably will move higher. If a micro-cap company that no one has ever heard of and has a float of only a few million shares post quarterly earnings and sales growth of over 100%, watch out. With so few shares, the bid/ask spread will usually be much wider, which forces traders to pay up for the stock. Once a few traders do and the stock gaps up, more people notice it, decide to pay up even more due to the great growth of the stock, and then the momentum train gets going. Often times, when these stocks start the big moves, other traders will also short the stock, deciding it is too far extended. These shorts just add fuel to the fire, forcing the stock price even higher. The series of charts at the end of this post show how fast low float stocks can move.

Part Two - Get Into These Companies As Soon as Possible

This is usually the hardest part. Finding these companies is not easy and often when you do notice them, it is after they have already gapped up so much that most people won't buy them. Since most earnings are released before the market opens or after the market closes, you can find earnings-related breakouts if you pay attention. I always check both the pre-market trading action and after-hours trading action daily to see if any stocks are gapping up more than 10% or so. I check here and here to find this information - you can check IBD and other sites as well, but the information might be delayed. If I see any stocks of interest, I will check the chart, check the earnings report, and make a decision. It is risky to buy any stock pre-market or after-hours, because you never know the true reaction of the market to an earnings report until the market actually opens. However, recognizing these opportunities at these times are often the most profitable situations to be in, and with big risk, sometimes comes big reward.

Some stocks, however, are so small or so unnoticed that they won't show up pre-market or after-hours, and some micro-cap stocks release earnings intraday. For me, what I do is keep my "top ten gainers" list for the Nasdaq and AMEX up on my quote screen throughout the day and periodically check on it to see if I missed any stocks making big moves. If one pops up, I will check out the earnings and the chart, and then go from there. This is how I found OFI on Thursday. I have no idea yet whether this will be a big winner - I don't think it will be huge, even though the earnings were great - but I was able to find it. Any time a stock is up over 10%, especially a stock you've never heard of before, it is worth investigating why that stock is up so much. Often, it will have to do with earnings.

Part Three - Ride the Momentum Upward Until Certain Technical Signals Tell You the Party May Be Over

This is probably the hardest part of the whole strategy, because holding these type of stocks can be very stressful and nerve-racking. If you do manage to catch one of these stocks early, the temptation to sell and lock in a quick 15-20% gain is very hard to resist. However, if the stocks holds the price lows of the day it gapped up, then you might have a big winner on your hands, and regardless of how difficult it is, you need to hold onto these stocks and let them go higher. You must realize, however, that these stocks can have wild swings, and they may fall 15-20% in one day due to their low floats.

Because of these wild swings, I like to use the 9 and 20 day moving averages as guides as to when to sell these type of stocks. I have found that often, the 9 day will act as support early in the stock's run (the first week or two) - as long as close above this level early on, I will hold it, even with a violent pullback. As the move progresses, the 20 day becomes secondary support. In these low float stocks, sell signs tend to pop up if these stocks break below the 20 day on very heavy volume. If you manage to get a large gain in one of these stocks and it had moved a significant amount, it is wise to set stops under these levels of support to lock in profits, because when the party is over, there is usually a mad rush to the door(see TRCR, TRT, and NGA below). If you buy properly and have a large gain, you may be also be able to hold on and use the 50 day moving average as support depending on your timeframe(see GHM and TRCR below). Catching just one or two of these stocks per year can make a great impact on your trading returns.

Below is a group of charts that show some earnings-related trades that occured in the last one to two years. All of these are lower-float charts and made very powerful moves very quickly. The longest holding period on any of these if you traded them perfectly would be around 6 months. The optimal holding period on some is only a few weeks to a month. It really depends on the stock.

Charts from Telechart2007, Courtesy of Worden Brothers, Inc.

This second group is to show how earnings affect the long-term prospects of stocks. This is the basic idea behind the CANSLIM method from IBD - find stocks with great growth and ride them higher. They don't necessarily use the idea of buying huge gap-ups because stocks are extended in these situations, but as you can see from these charts, sometimes those gap-ups, although scary to enter, are the exact perfect time to begin positions in these stocks. All of these charts are stocks with bigger capitalizations and more shares outstanding, so they don't move quite as fast. If you have the patience and discipline to hold onto these stocks, you can make huge returns. This is one area in my trading where I need to improve in a major way - the only earnings-related stocks I caught last year was CROX and had around a 70% gain in it, which was nice, but I wish I entered into some of the others listed here. Live and learn I guess.

Charts from Telechart2007, Courtesy of Worden Brothers, Inc.

Here are the basic summary points from the earnings-breakout strategy:

  • Look for quarterly earnings growth year over year should be up at least 50%; 100% or more is better.
  • Earnings should be positive - negative earnings don't work as well.
  • Quarterly sales growth year over year should be up at least 25%; higher is better.
  • Find stocks that have low floats and preferably haven't moved higher a great deal yet.
  • Enter in afterhours or on morning after earnings; add more later in the day if situation allows.
  • Initial stops should usually be below the gap low.
  • Once you have a nice gain (20% or more) tighten stops to below 9 or 20 day moving average.

Hope this helps explain the philosophy of looking for earning-related breakouts and how to play them properly. Here are the links from Stockbee and Solitary Trader I mentioned early that will explain these ideas in more detail. They put in the work with these posts and I want to make sure they get credit for the ideas presented above. Reading through these will hopefully help you master this very profitable strategy. It is one that I realize I need to focus on more, and by doing so, it will help me not overtrade and keep me in the very best stocks only.


bhh said...

Another great post. Thank you.

Vlada, Czech Republic said...

I agree, great post. I've bookmarked this one. Thanks for sharing.