With the broad indexes trading near all-time highs, expectations this earnings season are obviously sky-high. However, when investors (both retail and institutional alike) expect record-setting earnings growth there is always bound to be volatility with companies that miss targets or hit targets but fail to beat expectations by a big enough margin.
We’ve already seen this play out with Amazon (AMZN), which fell $272 on earnings recently, and Pinterest (PINS) which lost 18% following disappointing results.
While I really like the potential of these stocks to bounce back, since both are companies that are changing the world, particularly PINS (more on that one later), my experience tells me that I should wait at least three days before buying these stocks. I call it The Three-Day Rule.
I began my career on the floor of the Chicago Board of Options Exchange in 1999, straight out of college. For a year, I stood next to two options trading legends, soaking up all of their wisdom as their clerk. That year, the market ripped higher as virtually every dot-com stock exploded higher day after day. I learned a great deal during that bull run.
Here is a picture of a younger me (with more hair) in my trading pit on the CBOE.
Soon after I became a trader myself, and the Nasdaq fell apart. The dot-com bubble burst, and valuations were reset for virtually the entire market. I learned even more during those bearish years than during the bull market years!
One rule that I took away from the bear years—and that I continue to tell subscribers to my advisories—is about stocks that have taken a big dive.
The old trading rule that was hammered into my brain by my two trading legend mentors was this:
If a stock takes a big fall, whether it’s on earnings or some other news event, you MUST wait at least three trading days before even thinking about putting on a bullish position.
The rationale behind The Three-Day Rule is that if a large hedge fund or institution owns millions of shares of a stock, it won’t be able to sell out of its entire position in a day or two without causing the stock to fall.
Instead, the institution will parcel out its sales over a couple of days, so they don’t depress the stock and can sell at better prices.
Considering a Recent Earnings Miss
I may try to buy Pinterest (PINS) Calls in the coming days if my Unusual Options Screening tool tells me that big traders are stepping in and buying PINS stock options.
And if PINS Option Order Flow turns bullish, with the stock trading around 56, I might look to buy the November 60 Calls.
What makes buying these calls so attractive is that my downside is limited by my premium outlay on the trade: Right around $450 per call purchased. This is a significant discount to paying $5,600 for 100 shares of the stock. And if PINS stock stabilizes, and runs back to its old highs and beyond, my upside is unlimited!
However, if this earnings miss was a sign of bad things to come, and PINS is a short and the stock drops, the most I can lose on the trade is $450 per call purchased.
Since we’re in the midst of earnings season, there will inevitably be some big drops in stocks you have interest in buying. However, before buying the dip that first day, remember what all experienced floor traders refer to as The Three-Day Rule.
What personal earnings season rules do you play by when you see a big hit or a big miss?