Earnings Announcements Consistently Cause Massive Trading Gaps
A trading gap occurs when there is a sizable difference between the closing price and opening price the next trading day of a stock. It often occurs due to an earnings announcement after hours. These create excellent gap trading opportunities.
For example, on December 3, 2013, the biggest % price gainer on the New York Stock Exchange was Rex American Resources (NYSE: REX), an ethanol company. The headlines for that morning read, “REX American Resources Fiscal Third Quarter Diluted EPS Rise to $1.21 as Net Income Increases to $9.9 Million from $0.4 Million,” and the price jumped. This was among the best stocks to trade the opening gap due to its earnings release.
Research Shows Value Stocks React Better to Earnings Announcements
If a company’s earnings beat analysts estimates, it’s called a positive earnings surprise. If the company’s earnings fall short of analysts estimates, it’s called a negative earnings surprise. The evidence that value stocks beat growth stocks after earnings surprises is robust. Here, we’ll cite three studies showing that value stocks react better to earnings announcements than growth stocks do, making them excellent gap trading stocks.
In their 1999 paper “Earnings Surprises, Growth Expectations, and Stock Returns,” University Of Michigan accounting professors Douglas Skinner and Richard Sloan conclude that, “It is well-established that the realized returns of growth stocks have been low relative to other stocks. We show that this phenomenon is explained by a large and asymmetric response to negative earnings surprises for growth stocks.”
In a similar 2009 study, “When Two Anomalies meet: Post-Earnings-Announcement Drift and Value-Glamour Anomaly,” Zhipeng Yan and Yan Zhao find that, “…glamour stocks exhibit much larger negative drifts following negative earnings…while value stocks exhibit much larger positive drifts following positive earnings surprises…”
In a 2011 paper by the Brandes Institute “The Role of Expectations in Value and Glamour Stock Returns,” they write, “What happens when value and glamour stocks miss earnings expectation targets? Although, as expected, prices for glamour stocks have historically fallen, prices for value stocks have gone up.” Again, value wins.
First Gap Trading Strategy With Fidelity’s Free Stock Screener – Low P/E Stocks
First, go to Fidelity’s free stock screener. If you’re interested in, say, penny stocks to watch, set the price under your cutoff (definition of penny stock varies). If you’re interested in stocks to watch this week, select 1 week for “earnings announcement: days until.” If researching tech stocks to watch, select this under “industry.” Most importantly, screen for value stocks by using P/E (Price/TTM Earnings) and picking the lowest 20 % in the market (lowest decile outperforms the other four deciles in the studies). Buy shortly before the closing bell. If you are unable to monitor the stock price the next day, I recommend using a stop loss to protect against unfavorable earnings announcements.
Second Gap Trading Strategy With Fidelity’s Free Stock Screener – Low P/E Stocks With Beaten Down Prices
This is the same as the first method, except it adds the lowest 20% price performance in the market in the 5 days leading up to the earnings announcement. With poor price performance, it shows investors don’t have high hopes for the earnings, adding another contrarian twist to the value stock method.
Final Thoughts on Gap Trading Strategies
Both of these gap trading strategies take advantage of Warren Buffet’s famous method of, “Be fearful when others are greedy, and be greedy when others are fearful.” These stocks are beaten down because people don’t have high hopes for them. If, however, a positive earnings surprise occurs, a nice price increase should occur to give the stock a more fair market price. If the earnings aren’t very good, the stock shouldn’t fall as much as growth stocks would since nobody expected much anyway.
Only do this method if you can afford to have massive fluctuations and surprises, as this is an incredibly risky technique. Don’t expect to win every time. If you do enjoy exciting trading methods such as this, however, the research is unanimous that value stocks react better than growth stocks to earnings announcements.
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Institute, Brandes, The Role of Expectations in Value and Glamour Stock Returns (June 1, 2011). Journal of Behavioral Finance, 2011; Brandes Institute Research Paper No. 03-2011. Available at SSRN: http://ssrn.com/abstract=1905645
Skinner, Douglas J. and Sloan, Richard G., Earnings Surprises, Growth Expectations, and Stock Returns: Don’t Let an Earnings Torpedo Sink Your Portfolio (July 1999). Available at SSRN: http://ssrn.com/abstract=172060 or http://dx.doi.org/10.2139/ssrn.172060
Yan, Zhipeng and Zhao, Yan, When Two Anomalies Meet: The Post – Earnings Announcement Drift and the Value – Glamour Anomaly (November 22, 2011). Financial Analysts Journal, Vol. 67, No. 6, 2011. Available at SSRN: http://ssrn.com/abstract=1963308