Not all trading fits neatly into a form of analysis, not even technical analysis. The following strategies represent several of our favorite. In short, they work, but like anything, they are best used in the proper situations. Apply the rules of risk management you have learned and enjoy the benefit of these timeless techniques.
Throughout the book we addressed the factors that move markets, and in general these factors include fundamentals, technicals, and psychology. We stated that fundamentals answer the question “why” prices move, but this analysis is late. Technical analysis answers the question “when,” and is the chosen approach. The final, and probably hardest factor to measure, is psychology. Understanding the psychology of stock movements is often measured through technical indicators and attempts to answer the question “who?” Who would be a buyer and who would be a seller under certain circumstances? Big money can be made in a stock’s movement when there is a favorable combination of the three factors listed above to uncover profitable upside opportunities.
The focus of this section will be the study of a specific technical indicator, short interest, in an attempt to uncover situations where a “short squeeze” may develop in a stock. Before we get started with analyzing the idea, we need to remember that short selling is a strategy that attempts to capitalize on a decline in share value by selling stock at a high level and later purchasing the security at a lower price. The short seller therefore represents future demand because they must buy the stock back at some future date in order to close the trade. Of course, each participant will buy back their shares at different times, but as we will see, we can make certain assumptions based on the share price where fear begins to “squeeze” the short seller. This is the opportunity.
The biggest risk to a short seller is that instead of share prices dropping, the stock’s price rises. We will see later that a rising share price in a stock that is heavily shorted can lead to dramatic upward movement as short sellers add demand while covering losses. The motivation to buy back the stock by the short seller is often the fear of unlimited losses. When you buy a stock at $20 a share, the most you can lose is your entire investment, $20 a share. When you sell a stock short at $20, the potential for losses, in theory, is unlimited. The stock may rise to $40, $50, $60, or even more, as theoretically there is an unlimited upside risk! It is the fear of such an advance that can make for an explosive upside in a heavily shorted stock. The phenomenon of a rapidly rising stock with a large short interest is known as a short squeeze, and we will now explore the dynamics of how a short squeeze develops.
Before we continue, let us first cover some terminology. Short interest is defined as the total number of shares of a stock that have been sold short and not yet covered. When a person sells a stock short, exchange rules mandate that the order must be identified as a short sale. Because each short sale has to be identified as such, it is easy for the Exchanges to compile statistics on the total short interest in the market. This information is released to the public once per month by the different Exchanges. Short interest for Nasdaq stocks is tallied up on the fifteenth of each month, and that information is disseminated to the public eight business days later. For example, if the short interest is 1,500,000 shares as of August 15, that information is released to the public on August 27. Any changes to this number are released one month later. Obviously this practice can change with Exchange policy. It is the method of this strategy that matters most.
The short interest ratio (SIR) is the number of shares sold short (short interest) divided by the average daily volume for the previous month for the particular stock. This number is interpreted as the number of days it would take to cover (buy back) the shares sold short based on the average daily volume. The higher the ratio, the longer it would take to buy back borrowed shares. This often leads to dramatic upward momentum for the stock when the sellers become motivated to buy back their short positions. If the stock had a short position of 1,500,000 shares and an average daily volume of 500,000, then the SIR would be 3.0, meaning it would take three full days of average daily volume for the short sellers to cover their bearish bet. If the stock had an average daily volume of just 250,000 shares, then the SIR would be 6.0, meaning it would take six days of buying to cover their position. As a contrarian indicator, a higher SIR is desirable because it means it is more difficult to cover the position and the resulting buys have the potential to create significant short-term trading profits, i.e. the “short squeeze.”
A short squeeze develops when those who sold short the stock experience losses and groups of bearish traders attempt to cover their positions quickly. Short squeezes often occur because of a news event that changes investors’ perception as to the worth of a particular company. Another way a short squeeze can develop is when long holders of the stock push the price higher with aggressive buy orders in an attempt to tap into the emotional buying that a trapped short seller can provide. This can create fear on the part of the short seller. Obviously, if you are short a stock that is advancing, there is a point where it becomes fearful to continue holding the position. With that said, in order to eliminate the mounting losses and the emotional trauma of holding a big loser, the once pessimistic seller will often become a panicky buyer. It is this buying along with long-side momentum buyers that makes the stock advance at a rapid pace.
The first step in finding a good short squeeze candidate is to study the charts to see if there is any technical indication that it might be the proper time for a low risk entry into the stock. Any stock in a downtrend can be immediately eliminated because short sellers are more confident in a position that is moving in their favor. Eliminating situations that are not high probability candidates frees our time to focus on the strong stocks where the short sellers may be in trouble. At MarketWise we have proprietary databases of stocks that meet our technical criteria for an uptrending stock, but a great place to begin is to find stocks that are trading above a rising 50-day MA. If the stock is below the declining 50-day MA, you can eliminate it from the list and then focus on the stocks that are trading above the rising 50-day MA. A stock that is above a rising 50-day MA is in an uptrend and should be studied further on different timeframes to find where there may be the potential for resistance to halt the upward progress of the stock. If a stock is at a new high, it indicates that the only source of potential supply will come from profit takers, rather than people selling to get even on a position they may have been holding in their portfolios at a loss. A stock trading at a new high also indicates that it is unlikely that the short sellers are in a profitable position, and that may make them more motivated to cover their short position. See Figure 16-1.
FIGURE 16 - 1 The first step is to find a stock in an uptrend. This stock had broken out to an all-time high and pulled back to prior support on light volume. Anyone who had sold short in the past came into a losing position when the stock broke out and that added the potential for further demand.
After finding a stock in an uptrend, a quick look at the short interest table at the Nasdaq site is the next step in finding a good candidate for a short squeeze. Figure 16-2 shows that when the stock broke out in early May, the short position was near an all-time high, standing at 10,193,909 shares that had been sold short and not yet covered. Clearly the shorts appeared to be in trouble at this time. It is also important to note the high short-interest ratio at the time. The average daily volume in April was 457,574 shares, and at that rate it would take the shorts more than 22 days of buying to cover their position. This high ratio put the shorts in a precarious position, and for each share they repurchased it was like throwing gasoline into a raging fire. It was not going to be easy to cover this position.
FIGURE 16 - 2 There are numerous sources for finding the number of shares that are short for any individual stock and the corresponding ratio to average daily volume. The site we look at most frequently is www.nasdaq.com since this site offers information on the short position of all equities markets, not just the Nasdaq.
The next step is to overlay the short position onto the price chart to come up with an approximate level that the bulk of the short position was initiated at. Figure 16-3 shows that the short sellers in this stock were all in a losing position as the stock broke out to new highs. We can also figure that between November and April, while the stock traded in a range of $13.50 to $17, the short position was increased by nearly 7.5 million shares. That means that $17 should act as good support for the stock, assuming short sellers would look to cover their positions. If the stock were to pull back to $17. This pent-up demand lowers the risk with potential support just below the highs. This is a critical concept in understanding why resistance, once broken, tends to act as support. By understanding how much the short sellers are losing we can monitor the stock for anticipated urgent buying. This information answers a fundamental question as to who would buy the stock. By recognizing the large short position, we can understand the potential urgency buyers may have in the issue, which could be a key psychological development behind a buying frenzy in the stock.
FIGURE 16 - 3 From November 15 to April 15, 7.5 million shares of stock were sold short. By looking at this information on a chart, we can see that when the stock broke out to new all-time highs, all of those shares sold short were in a losing position, leaving them vulnerable to a short squeeze.
It is important to know that a large short-interest ratio, by itself, is not a reason for buying a stock in anticipation of a short squeeze. As with any other indicator, the short-interest ratio should not be used on a stand-alone basis. The informed trader will find an edge when there is a preponderance of indicators leading to a price advance. Short sellers who take large positions are typically sophisticated speculators who have done extensive research on their targeted company and are often right. Many times those who sell short have the right idea fundamentally, but their timing could be off. The correct time to sell a stock short is when it is either in or entering a downtrend. When a short position is initiated in a stock that is trending higher, there is real potential for big trouble for the shorts. As the stock continues higher in an uptrend, it often becomes tempting to sell short because the perception may be that “it is up too much” or “the P/E is too high.” However, as discussed throughout the book, these are expensive opinions to harbor. Professional traders realize that shorting a stock only once the stock rolls over and shows weakness is the higher percentage trade. Therefore, be careful who you are trading against. The true short squeeze stock candidate is when a security is in an uptrend that has attracted a large short interest and has strong fundamentals.
This leads to the final criteria to consider when choosing short squeeze candidates, the fundamentals. Although poor fundamentals would not preclude a stock from being a potential short squeeze target, a company with strong fundamentals would add to the source of demand and move prices higher. When looking at fundamentals on a momentum play, it is important not to look too deep. We will usually look at the company’s news headlines for sales and earnings information, new product developments, and analyst ratings changes. In the case of the stock above, a glance at the headlines shows news reported on May 5 that reads as follows: “Company Reports First Quarter 2003 Results; Revenue Increases 50%, Net Income Increases 79%, Company Increases Guidance.” Just reading this headline tells us the company is growing their business by selling more (revenue increase), they are more profitable than they were last year (net income up 79 percent), and business remains strong (increases guidance). On the day this fundamental news was reported, the stock advanced $1.05 on heavy volume; clearly the reaction from Wall Street was a positive one. The market believed the news.
When reviewing fundamentals, traders should be more interested in why others would buy or sell. It is important not to make a decision about the company, but only what others may think about the stock. There are many people who buy and sell stocks based on what the prospects for the company are, and we cannot ignore them in making our decisions because of the large impact they can have on price.
We should be able to quickly analyze the fundamental, technical, and psychological influences before making any trading decisions. When we have all three of these factors telling us the same conclusion (buy), we should act. Couple that with a high short-interest ratio and we have the ingredients for future demand. As you can see from Figure 16-4, the stock progressed nicely in its uptrend and doubled in price over the next five months.
FIGURE 16 - 4 From the original breakout point the stock continued higher in perfect stair-step fashion as the stock made higher highs and higher lows over the next five months.
In summary, short sellers are usually very savvy speculators; however, like any group of market participants, they aren’t always right. When shorts are wrong about the direction of a stock, the move higher can be dramatic, leading to some excellent short-term profits for traders who see a short squeeze situation developing. Like any indicator, short interest should not be used on a stand-alone basis, but it should become part of a trader’s arsenal. Since technical analysis is largely about measuring supply and demand, short sellers can become an excellent source of demand for a stock in an uptrend.
As touched upon in Chapter 10, the stochastic indicator is an oscillator. An oscillator is a technical indicator that measures rate of change and momentum within a defined range of 0 and 100. The indicator measures the mathematical relationship of a securities momentum and its signs of becoming overbought and oversold. It is important to understand “overbought” and “oversold” are terms that have no fundamental representation. They are technical terms that relate to standard deviation from a historical mean price. The true value of a stochastic oscillator mathematically measures when a security is prone to reversal.
Trending stocks tend to remain in trend as long as closing prices continue to close near their highs in uptrend as lower trending securities close near their lows. See Figure 16-5. The stochastic indicator comes alive when this pattern is broken, acting as an early signal of impending reversal. In this case, the opposite is true whereby higher trending stocks close near their lows of the period and lower trending stocks close near their highs.
FIGURE 16 - 5 Notice that while uptrending most every candle closes near the high of its range. When in a downtrend the candles close near the lows for most every candle. As long as prices tend to close in the direction of the trend, reversal is still unlikely.
In mathematical terms the close in relation to the overall range is measured by comparing the close of the period to the low, divided by the high minus the low. See Figure 16-6.
FIGURE 16 - 6 In this simple, one-period example, the stochastic indicator measures the closing price to both the low (A) and the high (B) of the period.
The actual formula for stochastics is given by:
where
C = current close
L(Period) = Low of the period
H(Period) = High of the period
Again refer to Figure 16-6. As distance A gets closer to the high, %K gets larger until A = B then %K = 100. If the close trades lower, A moves toward the low and K% gets smaller until A = L then %K = 0. This is a simple example using only one period for the stochastic indicator.
If this concept seems familiar, look back to elasticity and the expansion of range we discussed in Chapter 5. The stochastic indicator measures the elasticity of price within the period selected. If the price is near or breaks the high of the range the stochastic indicator is pushed higher. As a new range is set the stochastic indicator will trade within the new range. When price reverses direction and trades off the highs of the period, it will “bend over” the stochastic and begin to reflect the reversal potential of the prevailing trend. When you apply the stochastic indicator to more than one period, the indicator compares the current close to the highest high and the lowest low of the period. See Figure 16-7. Note that the stochastic indicator is comparing the current close to the elastic range of the past 14 periods. The stochastic indicator that was used in the previous examples is plotted as a line that oscillates from 0 to 100 and is designated %K. The %K line can be very sensitive and prone to giving too many buy and sell signals, so there are derivatives of %K to desensitize the indicator or slow it down. The %D line is one such derivative and is typically plotted with %K and is the MA of the %K. Just as MAs can be used to smooth out the volatility in stock prices, the %D line takes some of the volatility out of the %K line. Also realize that the period of the %D line can be customized but is typically the three-period MA of %K.
FIGURE 16 - 7 Stochastic indicator applied to 14 periods.
The stochastic indicator is typically plotted beneath the security on a scale from 0 to 100. Traditionally the indicator is said to be in over-bought territory if it gets above the 80 line. It is considered oversold if the indicator falls beneath the 20 line. See Figure 16-8.
FIGURE 16 - 8 The traditional stochastic indications of %K and %D.
As the indicator oscillates between 0 and 100, it gains actionable levels at 80 and 20. It doesn’t tell you that it will happen for sure. It just tells you that the underlying trend is getting a bit extended and a correction is probable. The 80 and 20 lines are traditionally used but if using stochastics on strongly trending stocks, the lines might have to be adjusted based on the individual stock’s historical patterns. Some issues have a stochastic range at 90 and 10 for example. Therefore, it is best to relate each individual issue to its own historical relationship. For example if a stock is uptrending strongly, on the pullbacks the stochastic may not penetrate the 20 level, and it might only come down to 30. In cases like this you should adjust your oversold zone accordingly. The reverse is true for a downtrending stock.
When a stock is uptrending as the closes of the periods are near their highs, the stochastic indicator is pushed higher. As the close begins to occur away from the high of the range, the stochastic indicator is pushed over and signals the potential overbought condition. Note the movement of the stochastic indicator upon each successive candle entering the equation in Figure 16-9. Also take note that the candle that pushes the stochastic over is the classic shooting star candle which signals a reversal and halts uptrends. The rationale of the shooting star signifies the bulls’ last momentous rally. The fact that the bulls cannot maintain the rally and close near the highs of the period helps confirm the bulls are tired and the bears are gaining control.
FIGURE 16 - 9 The stochastic indicator begins to flatten out and gets pushed over as the closes occur off the high of the period.
When a security is downtrending, the stochastic is pushed lower as the closes are near the low of the period being measured. Once the closes begin to move higher in the range, the stochastic begins to flatten out and moves higher. Notice how the stochastic indicator moves with each successive candle. The classic hammer candle that indicates a reversal also pushes the stochastic indicator higher. See Figure 16-10.
FIGURE 16 - 10 The stochastic indicator is pushed lower by closes near the lows, flattens out, and then begins to rise as the closes move off the low of the range.
Referring to Figure 16-11, the stochastic indicator’s %K line crosses the %D line in oversold territory, then both lines exit the oversold zone and a buy signal is given. As the stock trades higher the stochastic indicator is pushed higher until it gets into the over-bought zone. Once in the overbought zone the %K crosses the %D line and both lines exit the overbought zone and the sell signal is given. The subsequent action of the stock is lower. The important signal to recognize in overbought territory is the %K crossing the %D, with %K exiting the overbought zone with %D, but beneath it. Conversely, in oversold territory, %K will cross %D and both will exit oversold with %K above %D.
FIGURE 16 - 11 The traditional buy and sell signals, the cross of %K over %D in the overbought or oversold zone, and an exit of both %K and %D from the extreme zone. %K is represented by the solid line and %D the dashed line.
There are some patterns that the stochastic indicator gives that defy the traditional stochastic theory. Under certain circumstances, these create tradable signals that, when used in conjunction with traditional technical analysis, can lead to profitable moves. The continuation up pattern is one such situation. This pattern works best when a security has been basing in a stage 1 accumulation. Upon moving from an accumulation phase to a markup phase, the stochastic indicator moves into the overbought zone. It is at this time long positions are initiated. See Figure 16-12.
FIGURE 16 - 12 The continuation up pattern.
The long positions are exited as the stochastic indicator leaves the overbought zone. The philosophy behind the market action is that once a market becomes overbought it tends to remain overbought. The continuation down pattern is the opposite of the continuation up pattern. It works best when a stock is trading in a stage 3 distribution pattern. As the stock breaks out of the distribution range the stochastic indicator moves into the oversold territory. As the stochastic enters the oversold zone, short positions are initiated. The short position is held until the stochastic leaves the oversold zone. The theory behind trading this pattern is that once a stock becomes oversold it tends to remain oversold. See Figure 16-13. In simple terms, once a trend is intact, it tends to stay intact until strong signs of reversal begin to appear. The stochastic is confirmation of the reversal.
FIGURE 16 - 13 The continuation down pattern.
The divergence of price and stochastics is another nontraditional way to use stochastics. The divergence can be an early warning sign of a change in trend. The bullish divergence between price and stochastic typically occurs in a stock that is in a downtrend that is about to reverse direction. As the price makes a lower low the stochastics make a higher low. This is the divergence. After the divergence takes place wait for the downtrend to be broken by price making a higher high. It is at this point that longs are initiated. When used correctly divergences can lead to many profitable trades. See Figure 16-14.
FIGURE 16 - 14 A bullish divergence between price and stochastics.
The reverse of the bullish divergence is the bearish divergence. The bearish setup occurs while a stock is in an uptrend but is ready to turn lower. As the stock price is able to make another push higher, the stochastic indicator makes a lower high. This is the point when the divergence occurs. Short positions are initiated as the stock breaks its uptrend. See Figure 16-15.
FIGURE 16 - 15 A bearish divergence.
The stochastic indicator can point you in the direction of profitable trades, but remember that the indicator is a tool and like any other indicator or pattern it must be used in the context of the larger picture.
Earnings releases are one of Wall Street’s biggest news events. Trade volume increases dramatically during earnings season as dumb money rushes into the market on the heels of media hype. We have studied the potential manipulations from companies reporting earnings, Wall Street firms, and the analysts that work for them. Accounting principles used during this season seem to be stretched to the limits if not exceeding industry standards. To make matters worse, companies love to use jargon that even Generally Accepted Accounting Principles (GAAP) can’t seem to understand. Earnings seem to have more ways of being reported than Baskin Robbins has ice cream flavors. Terms like “one-time charge,” “beat the street,” and “consensus earnings estimate” are examples of how companies can make earnings look better than they are. This leaves investors looking to analysts to make sense of the jargon, who only make matters worse with their own terminology.
Perhaps the company reporting earnings wants Wall Street to focus on their future more than their present due to current challenges they may be having. Then they like to talk about “guidance” and “pro forma,” which are simply ways of looking forward or guessing what the next quarter or year will look like. This is nothing more than a distraction. Technology companies love to say things like, “on a pro forma basis we earned 15 cents a share,” when in reality this has nothing to do with current earnings that may only be 2 cents a share. They also like to “pre-announce” to help soften bad news that may come forward on the day earnings are to be released. This helps cushion the impact the actual news may have on the stock’s price. This kind of activity contributes to another term, “the whisper number.” Now that sounds really important and I guess we are expected to believe that only important insiders could know what that number is. Perhaps we should wait to respond to the “earnings surprise,” which sounds like a party! This little emotional term really gets the market frothy, when in reality all it really means is a better than expected earnings report than the “guidance” or “consensus estimate” thought.
The reaction of a stock’s price to earnings announcements is an area that offers you substantial trading opportunities, but not for the ridiculous reasons and terminology stated above. Wall Street’s jargon and reporting process makes earnings the most misunderstood and mistraded stock play there is. I could go on, but you get the point. I suggest you not even worry about it! Even if you understand the language of Wall Street, you can’t trust it enough to trade on the news. Wall Street wants you to feel confused, that way you will use their translators, the analysts and brokers. Earnings are one of their very favorite ways to confuse the public. Our focus once again will be to look to the charts with this market cliché in mind.
This is one market term I don’t want you to forget. Trading on earnings reports offers at least three distinct trading opportunities based on market perceptions of the amateur. How people perceive earnings reports and the jargon associated with them determines how they trade. The public will react to things that professional traders won’t. This reaction from the public produces much of the opportunity for the professionals because earnings announcements are foreseeable events and the trading that takes place is based on the perception and hype surrounding them. The astute trader searches for price patterns to determine what the professionals are doing in anticipation of earnings, and fades what the amateur is expected to do once earnings are released. The price action on the charts weeks prior to earnings is the rumor part of the equation. The expected price action based on late amateur participation is the fact part of the equation. Keep in mind, this approach only applies to stocks that represent positive price action in anticipation of earnings. Shares that are depressed weeks prior to earnings are best ignored, since this would imply that once the poor news was released, professionals would buy the weakness. Not a good idea! Poor earnings, missing the consensus estimates, lower guidance, etc., can substantially punish a stock for long periods of time. Conversely, based on fact that the market discounts fundamentals in its price, this play works best when good earnings are expected, as seen through the price patterns weeks earlier. In other words, this is only a bullish play.
Professionals do not wait for the news. Instead, they trade ahead of it. Professionals look for money to flow into the stock prior to the earnings reports. Then they join that trend long before the report comes out. Traders who can read the directional bias created by the smart money taking an early position will reduce market risk greatly while increasing profit potential. Traders will look for volume to build over the normal range of the stock, and then determine on which side of the market the volume is flowing. Results come from taking risks early and not waiting for the news to be actually reported. Investors who wait to buy stock based on news reports typically lose. If a positive earnings result is expected, it will likely show on the charts. The money flow of the buying professionals generally drives the stock higher weeks before the actual figures are released. The amateurs wait for “certainty” or the actual earnings news to be released before taking action, which creates the perfect opportunity for the professional traders to sell their long positions into the buying public. This is the reason why stocks often reverse their positive direction after the release of seemingly good news. The explanation is that the stock had already discounted the news by trading up several points on the expectation of good earnings. When the earnings are finally released, professionals drive prices lower by taking profits and selling the now overvalued stock to the amateurs rushing in to buy on the good news!
To recognize where the pros are putting the money, you need to pay close attention to the price patterns of the stock several weeks before the company will report. If the trend proves positive and is confirmed with good technicals, join it as soon as possible. Do not wait for too much certainty or you will miss the low risk entry. Keep in mind, as the reporting day approaches, the likely results will be price stability (consolidation) or even weakness as professionals are taking profits in spite of the fact that amateurs may be starting to buy. The early amateur buying generally occurs because the media is more actively reporting the earnings event, with plenty of analysts willing to put in face time on television to spread their jargon and arouse emotions. The amateur loves to “bet” on outcomes, and the more aggressive dumb money starts to show up early. They will be joined soon by their less aggressive peers in the morning following the release of earnings. This is a very risky stage of the trade and the time to sell into the public buying regardless of outcome. Remember the time stop. If the trade has not worked by the day earnings are to be released, it is likely it will not. Staying in the trade beyond this time horizon puts you in a category you do not want to be in—dumb money. A word of caution, the first time you use this technique you may have a tendency to try and make the trade work no matter what, but choose stocks that only have a good earnings history and strong technical merits as we have discussed throughout the text. See Figure 16-16.
FIGURE 16 - 16 One tradable scenario for earnings releases. Notice how the security is bid up going into earnings, then sells off after the earnings are released.
The following is an example that demonstrates the earnings play concept. XYZ Corp is a company that has good fundamentals and is technically moving higher. The chart is shown in Figure 16-17.
FIGURE 16 - 17 The chart of XYZ Corp. The company has good fundamentals and has traded higher going into the earnings release date.
The 10-Q report for XYZ Corp is shown in Figure 16-18. Note the strong fundamentals.
FIGURE 16 - 18 The 10-Q report released by XYZ Corp in mid-August. Notice that the net revenues and the earnings have increased over the past three months and the past six months.
After studying the technicals and the fundamentals, the dumb money might be inclined to buy the stock going into earnings. The fundamentals are likely to remain good and the trend of the stock is to go higher, but herein lies the trap.
The analyst’s consensus for the earnings of XYZ Corporation would have was $0.26. After the close on the earnings release date, XYZ Corporation releases earnings that are better than expected at $0.28 per share. See Figure 16-19.
FIGURE 16 - 19 The report filed to the SEC that announced its earnings after the close in October. Notice that XYZ Corp beat the consensus estimate by $0.02.
Examining Figure 16-19, notice that the fundamentals are solid; the revenues are increasing and the earnings are increasing. The company also beat the analysts’ projected estimate for earnings.
The following price action of the stock is shown in Figure 16-20.
FIGURE 16 - 20 XYZ Corp moves higher prior to the earnings release date, then subsequently sells off.
After better than expected earnings were released, the stock sold off. The amateurs bought the stock going into earnings on anticipation of good fundamentals, and they were right about the fundamental information that was released, but they were severely punished by the following price action of the stock.
The price action of XYZ Corp is an ideal example of the “buy the rumor and sell the news” concept. With solid fundamentals and technicals, the professionals buy the stock prior to the next earnings release. As earnings are announced professionals sell the stock, creating downward movement even after better-than-expected earnings reports.
Many patterns exist in the market that provide the trader and investor with a statistical edge. The most important aspect of market engagement is to understand the timeframe for which you are engaged. The methods discussed in this chapter offer timeless strategies that are based on a psychological and mathematical basis. The majority of participants do not seek to measure the human condition. The ability to measure this behavior and illustrate patterns that continually repeat is the professional participant’s advantage. It has been often asked, “if these patterns become well known, isn’t it likely they will be traded by other participants to the point that their value will diminish or dissipate?” The answer is—not likely. People change, but seldom. The fact is, most participants will continue to be influenced by the news, analysts, and their brokers. Most participants are lazy, and the fact that our work is not easy is an advantage. Nothing in life worthwhile is easy. As long as the work is challenging, the amateur will seek the easy path, and the professional will continue to represent smart money. Welcome to the world of smart money!
