Nothing can be more frustrating for a trader than a company delivering a big earnings number, positive drug data or another fundamentally positive headline only to have the company’s stock plummet after the news breaks.
It’s market reactions such as these that frustrate new traders and make it seem as if the stock market is rigged to people who don’t fully understand the reasoning behind these sell-offs.
There’s an old adage on Wall Street that says traders should buy the rumor and sell the news. Here’s how that idea works, and how traders can use it to stay ahead of earnings surprises that could be costly.
The first thing to understand when it comes to trading highly-anticipated market catalysts is that the stock market is forward-looking. Forward-looking means that the share price of a stock doesn’t represent the value of the company’s past performance. Instead, a stock’s current price represents the value investors assign to its future performance.
This idea makes sense because investors only buy a stock with some expectation that it will perform better in the future. Past performance is often a good indicator of future performance, but it’s the future performance that actually matters to the market.
Given that the stock market is forward-looking, the next idea to understand ahead of a potential catalyst such as an earnings report is that a stock’s reaction to the catalyst will be relative to the market’s expectations, not the actual news itself.
For example, any investor with a basic understanding of business fundamentals knows that double-digit earnings growth is a sign of a strong company and a bright future. However, if a company reports 10 percent earnings growth when the market was expecting 15 percent growth, the stock will likely drop. It’s not that 10 percent earnings growth is a bad sign, it’s just that it didn’t live up to the growth number the market had already priced into the stock.
Once traders understand how markets anticipate and react to major events, there are several common ways to trade them.
The first step in the adage is to buy the rumor. If a trader has a good idea that a company will deliver a strong earnings report, the time to buy the stock is well before its earnings date. Assuming the thesis is correct, other buyers will also likely be buying the stock ahead of the earnings date, driving the share price higher. Ironically, traders who predict good news can
often sell a stock for a large profit before the news even comes out as other traders pile into the stock.
After the big earnings number comes out, there could be a potential short selling opportunity. When a stock has been steadily climbing higher for weeks ahead of a catalyst like an earnings report, it is a clear sign that market expectations are extremely high. As a result, even good news will often be met with selling pressure and could drive the share price down.
In addition, stocks will often decline following a big news item simply due to bulls taking profits and closing their positions. Biotech stocks often go months or years between reporting sets of study data. Once a set of strong data comes out, traders will move on to another stock, but they have to sell their shares first. As a result, new data can drive a large initial pop in biotech stocks, but they often drift back lower in the subsequent weeks.
Companies, headlines, and earnings numbers don’t move the stock market. Traders move the stock market by buying and selling shares. When a stock’s movement seems unfair, it’s not necessarily a sign that the market is rigged. By putting yourself in the shoes of other traders and understanding their motivations, predicting stock market swings can become much less frustrating.
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