Profit Without Prediction

There are tons of complex trading strategies out there. And they all invariably promise to reward investors with unheard-of profits. But in my experience in investment banking and as a financial analyst, they all inevitably fail. They’re just too complicated for their own good.

Seeing these kinds of debacles in real time taught me the intrinsic truth of the old acronym KISS: keep it simple, stupid. I mean, investing is supposed to be simple. The most basic lesson for all investors is to buy low and sell high. What could be less complex? Seriously, a third-grader can understand that one.

Fortunately for us, there are a few simple-to-use strategies for profiting in the stock market. These are all incredibly easy to execute. Maybe even too easy. That’s probably why so many investors ignore them and shell out so much cash for the complex ones… the ones with big words and esoteric terms like algorithmic multi-conditional divergence breakout.

Value investing, dividend reinvestment, buy-and-hold, bottom fishing. Those just don’t sound as impressive. But the returns you get in the long run really are.

And there’s another very simple strategy that will let you profit in the short term, too. You can use it to take advantage of earnings announcements even after the stock’s already reacted.

It’s called post-earnings announcement drift, or PEAD. And it’s one of the simplest and most profitable strategies I’ve ever used.

Investing on Hindsight

You might think once earnings are announced, that information is seen in a stock price immediately. Going by the efficient markets theory, it is. But that’s not true. Markets aren’t efficient. And that’s how you make money from them.

Be it investor under-reaction or earnings momentum translating into stock momentum, this strategy works. And it throws a monkey wrench into the efficient markets theory.

This is going to sound pretty obvious when I say it, but here I go: When a company beats earnings estimates, prices typically go up. And when it misses, they go down. Duh, right? Thanks for wasting my time. But wait. There’s more.

Source: Wall Street Oasis

That upward momentum can continue for as long as two months after the announcement. And it’s a perfect opportunity to scoop up some quick, easy profits.

The Simplest Strategy

There are a handful of ways you can play this information inefficiency. But the easiest is buying a stock that’s just had an earnings surprise. I like to give it a day or so before jumping in. Sure, I’m going to miss out on that initial frenzy. But I’m also going to miss out on any correction that comes immediately after.

Take Cree, Inc. (NASDAQ: CREE), for example. It reported a gigantic earnings beat earlier this week. I mean really blew estimates out of the water. Management reported EPS a full 100% higher than expected.

And the stock went through the roof. It closed the day before at $27.41. Then management reported before the open, and the stock shot up over 15% to a high of $31.64. And then the frenzy died down, and it closed the day at $28.83. That’s still a 5% gain from the previous close. But everyone who bought in near the high lost even more. The close was almost 9% lower than the high.

That’s the exact opposite of buying low and selling high. And it’s a surefire way to lose money.

But investors who held out and waited for that drop are looking much smarter. They don’t have a 15% profit yet. But they didn’t lose 9%, either. And Cree is still on the move up. According to research by people way smarter than me, it’s likely to keep moving up for the next couple of weeks, perhaps even the next two months.

And this strategy works in reverse, too. Stocks that miss estimates are destined to fall and keep falling. So if it’s in your wheelhouse, you can short those.

Pretty simple, right? Buy winners and short losers. And you can turn a 10% profit, maybe more, in just a few weeks.

A Little Less Simple, A Lot More Profitable

But don’t worry. If you want more than 10%, PEAD can still work for you. How, you ask?

One word: options.

You probably already know that you can turn a tidy profit from a good options trade. They move much faster than stocks, so it makes perfect sense. A 3% move up in a stock can give you a 30% move up in an option, sometimes even more.

So maximize those PEAD profits with a still simple strategy.

When a company beats earnings, buy calls. When it misses, buy puts. It gets a little more complicated when deciding what calls or puts to buy, but not that much.

Look for options that expire in a month or two and are a few dollars away from the current price. Remember, a small move in the stock price means a big move in the option price.

Also, don’t forget the time value of options. The closer they are to expiration, the less they’re worth. So don’t go buying stuff that expires the same month as the announcement.

It’s that simple. Get in, get out, move on. You can make 30% or more in just a few days.

Something to Get You Started

I’m always looking for opportunities like these. And since we’re in the thick of earnings season, they’re pretty abundant right now. Here are a couple ideas to get you started.

• Cree, Inc. (NASDAQ: CREE) — You already know these guys beat expectations by 100% this week. And with a beat like that, the drift is likely to last several more weeks. So a long stock or call position is the way to go here. I’d be looking at the March regular options. They expire on the 17th. The stock is around $29 right now, so look at the $30–$32 strike prices. As I write, they’re up between 24% and 40%. If the price has moved up by the time you’re reading this, then look at the strikes a little higher.

• Freeport-McMoRan (NYSE: FCX) — Freeport’s EPS came in 24% below expectations on Wednesday. And the stock’s down about 7% since. A short stock position or a long put trade is the way to go here. Take a look at the regular options again. There’s a lot more liquidity with those, so it’s easier to get out of your trade. And since the stock is around $16, take a look at the strikes between $13 and $15. The ones that expire on February 17th are on the move. Again, as the price changes, so should the strike prices you’re considering.

You can find more using the stock screener I covered in my top free financial resources article. Set the “Earnings Date” filter to “Previous 5 days,” and you’re ready to go.

Follow the Rules

Just remember a few simple rules, and you’ll see your profits grow and grow:

1. The bigger the beat, the higher (and longer) the upward trend.
2. The bigger the miss, the deeper (and longer) the downward trend.
3. Be patient. Don’t get caught up in the emotional trades.
4. Set a profit goal. Know how much you want to make.
5. Don’t get greedy. Once you hit your goal, get out of the trade.
6. Pay attention, especially with those fast-moving options.

That’s it. Stick to those simple rules, and your winners will far outnumber your losers.

The Simplest Strategies are the Best Strategies

And don’t forget about those other easy-to-use strategies. Buy companies that are priced below their intrinsic value. Buy companies that pay dividends, and then reinvest those payments. Focus on the long term, too, and hold onto those stocks. And when the market presents an opportunity to get a solid company at a discount, take it.

And, of course, keep reading Wealth Daily. There’s a reason more than 6,000 Wall Street pros do.

To investing with integrity (and keeping things simple),

Jason Williams
Wealth Daily