Earnings season is upon us and U.S. equity markets can provide bountiful trading opportunities for those who put in the “work”. Seasoned traders understand there are four Super Bowls a year for volatility, momentum and liquidity and that is earnings season. The real work entails maintaining a consistent morning research and preparation routine to optimize your time and efforts. Efficiency is the name of the game. We will go over a sample morning routine during the earnings season focusing on trading gappers and dumpers.
Construct Your Gapper Watch List Pre-Market
Most brokerage platforms provide a list of pre-market gapping stocks. We like to select stocks that are gapping up or down by at least 8-percent for stocks trading above $50 and 15-percent for stocks trading under $50. During earnings season, we filter for stocks gapping in reaction to the earnings report. Watching the scrolling CNBC ticker can also provide the most active gapper stocks and they will likely be reporting on the biggest widely traded movers. It’s ideal to prioritize stocks that you are familiar with. Once you identify up to eight candidates, it’s time to quickly analyze each stock fundamentally and technically, depending on which type of research you prefer. Remember, focus on the reaction and not the reason. Therefore, chart analysis will matter the most for intraday trading.
Filter Down the Candidates
As a rule, stick to stocks you are familiar with. Don’t try to rationalize the reason for the gap. There will be stocks that gap higher despite missing earnings estimates or guiding down because Wall Street was more focus on different metrics like a huge jump in monthly-active-users (MAUs). Vice versa, a stock may gap down despite blowing out the estimates to the upside because they missed whisper numbers, or the gains were already priced in triggering a sell the news reaction. Don’t try to make sense of the gaps. The goal is to capitalize on the exceptional volatility that gaps provide. If you decide to play a new stock, make sure you watch the behavior for the first 30-minutes.
Find Sympathy Stocks
Most widely traded stocks move in groups and thus have sympathy stocks that can be traded. For example, the casino sector moves together lead by Wynn Resorts (NYSE: WYNN), Las Vegas Sands (NYSE: LVS) and MGM Resorts (NYSE: MGM). If WYNN gaps on earnings, you can play LVS and MGM in sympathy especially if you has a smaller account and wish to get more bang for your buck. The best way to confirm the correlation is just to view the charts side-by-side to confirm. This also enables you to spot negative correlation and use that lagging stock as an opportunity to catch-up to the leader stocks. For example, NVIDIA (NASDAQ: NVDA) may be too expensive or unfamiliar to you, but Advanced Micro Devices (NASDAQ: AMD) tends to move together as a sympathy peer stock and can be played using NVDA as the lead, since they are both graphic processor unit (GPU) makers.
Select Four Gappers and Sympathy Stocks
We like to create a list of up to four gappers and add one or two sympathy stocks, which are peer stocks that tend to move together. This enables us to play the “pin” action as peers stocks tend to react with the gapper stock. It’s important to have multiple stocks on your watch list so if one set-up falls flat, you have alternate choices of stocks to play. Diversifying your list helps to prevent getting trapped in a single stock because there are no other options to trade. This is critical. If the mousetrap doesn’t work for one, move along to another stock your watch list.
Analyze the Technicals
For each stock on your watch list, it’s critical to have a full view of the “playing field”. This means analyzing the stock top-down from wider time frames to the smaller intraday time frames. We like to start with a monthly, weekly and daily chart. Taking the gap into consideration, it’s important to note if shares are trading significantly above or below the Bollinger Bands (BBs) and any of the wider time frames. The rifle charts can be used to filter through the playing field. The monthly and weekly BB price levels are important to note as prices tend to either deflect at these levels on gaps, but slingshot hard once breached. For example, if a stock gaps above the 40.60 weekly upper BB, it may defend that level on pullbacks but once it falls back under then gravity kicks in as selling pressure mounts.
Let the Trading Plan Materialize
The purpose of the pre-market technical analysis is to spot price inflection points that will cause a reaction once tested. Overextension beyond monthly and weekly upper BBs are key price inflection points. Other price inflection levels are Fibonacci (fib) retracement and extension levels especially the 0.618 fibs and historical support and resistance level trend lines. The goal is to mark key price levels to react to when they are tested like bumpers on a pinball table. This allows an initial trading game plan to materialize and enables you to place bids and offers ahead of time. In upcoming articles, we will delve into identifying common gapper and dumper set-ups, pacing intraday and higher probability patterns to apply to earnings reaction gappers.