As we are making our way through yet another season of earnings reports, we are all but forced to notice that some stocks have dramatic reactions either just before or just after their earnings are announced. On the surface, these reactions appear to be completely random, but what if they aren’t?
Is it possible that a quantitative strategy could be designed to isolate and profit from the stocks that are going to make huge moves right before or after their earnings announcements?
Wesley Gray from Turnkey Analyst shared a summary of a paper that built a quantitative strategy around the concept of earnings announcement moves. The paper is titled Limited Attention and the Earnings Announcement Returns of Past Winners, and it was written by David Aboody, Reuven Lehavy, and Brett Trueman.
The strategy that the paper presents isolates the best candidates for big earnings announcement moves. Then, it takes long positions as the stocks build excitement heading into their earnings announcement and shorts the stocks as they decline following their announcements.
Segmenting the Best Stocks
One of the key findings of the of the paper was that leading stocks have a much more dramatic reaction to their earnings announcements than the general stock market does.
When the performance of all stocks in relation to their earnings reports is charted, there appears to be a slight run up, but nothing significant. On the other hand, when the very best performing stocks are isolated, the reaction around their earnings releases becomes much more pronounced.
The paper segments the best stocks by ranking all stocks by their momentum for the previous 12 month period. Then, all of the stocks are divided into percentiles, and only the top 1% are used for the strategy. The bottom 99% of all stocks are eliminated.
Trading the Earnings Announcement
The data provided in the paper clearly shows that top stocks are likely to see a spike in returns leading up to the announcement of their earnings. Then, the same basket of stocks generally sees a quick decline in the days immediately following the earnings report. Obviously there are exceptions to this, but top stocks as a whole are very consistent in this behavior.
The paper shows that the top stock will increase an average of 1.58% in the four days leading up to their earnings announcement through the open of the first day after the announcement. Those same stocks will then decrease an average of 1.86% the first day after their earnings announcement through the fifth day after their earnings announcement.
The strategy that the paper proposes takes a long position in each of the top stocks at the open four days prior to their earnings announcement. Then, it sells the long position at the open of the first day following the earnings announcement. It also opens a short position at the open of the first day following the earnings announcement and holds that short position through the close of the fifth day following the earnings announcement.
This strategy averages a return of 3.05% on each trade, but there will also be huge outliers to contend with.