Why the Earnings Gap is a Gamble
A lot of people have asked what my 5DPEG (Pre-Earnings Game) is all about and why I don’t trade the Earnings Gap.
To cut a very long story short; its Gambling.
Am I justified to say that?
Well, lets look at the obvious facts. No one knows for certain which way the gap will go simply because there are too many variables that can alter the direction of the gap before it even happens.
Regardless of whether the company beats its earnings or not, forward guidance is one of the main factors that will dictate the gap’s direction. While simple fundamental analysis will tell you if earnings are going to be good or not, there is no real way of knowing if the forward guidance will be good or sometimes, good enough.
Analysts are also a key factor. Take AAPL of Oct 2005 – record earnings, record revenues and outstanding forward guidance. Still the stock went down. Why? Because the analysts said, “Not good enough.”
Likewise, GS. Record earnings so much so they could pay out their C-Level officers $50 million each and still come out on top. Yet they went down … again, “Not good enough.”
Then you have the other extremes when companies like BSC last quarter revealed the worst kept secret in the business – sucky earnings. Just when you thought you could short it for a gap down, they announce a massive Buy-Back that got the investors running to cover their shorts.
Other instances of sucky earnings going north include Stock-Split announcements, sector rotation, earnings sympathy and a whole lot more.
Sometimes, nothing stands in the company’s way of a clear gap. The analysts are happy with the result, guidance is good, market has been bullish, sector is in rotation … in a nutshell, clear blue skies. Then the market releases the worse Non-Farm Payrolls in over 5 years!
Need I go on?
Playing the earnings gap is more risky than putting $7 on a couple of System 7s plus $3 for 6 Ordinary Entries every Monday and Thursday.
So why bother? I can’t fathom why people would actually believe that such trading strategies (if you can call it that) can actually make money. Okay, by the rule of numbers, you will get lucky sometimes. But if gambling is what you like, remember that the house always wins the numbers game.
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