, he madenearly $1,550 or 10%.
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193
JLG Industries (Machinery, NYSE, JLG)2019
18
Sold
17
SymmetricalTriangle
16
Bought15
14
A13
04
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan 05
Feb
12
FIGURE 8.5 Jake bought after the breakout from a symmetrical triangleand sold the day prices took off.
Look what he could have made if he hung on. The stock peaked at20.26. If he sold at that price, he would have made 39%, or about$6,000.
Bad Earnings Surprise“I fell in love,” Jake said as he walked into the office, a wide grin pastedon his face. His dimple made the requisite appearance.“What’s his name?”“Funny. Real funny.” He walked over to my computer and punchedin a stock symbol then pointed at the screen. “I fell in love with HughesSupply.”Before I get to his trade, let me tell you about bad earnings surprises. When a company announces earnings, the market can have one ofthree possible reactions. The stock might go up, go down, or do nothing.This section deals with those surprises that break out downward. By
EVENT PATTERNS
194
Home Depot, Inc. (Retail Building Supply, NYSE, HD)5452504846
A
EarningsReleased
44
Flag
424038
BroadeningWedge,Descending
3634323028272625242322
02
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
21
FIGURE 8.6 An earnings announcement sent shares cascading lower.
break out downward, I mean price closes below the low posted on theday of announced earnings. Figure 8.6 shows the two examples.The first announcement happened at point A. The results beatthe consensus estimate, but the stock dropped anyway, closing belowthe low posted on the announcement day two days later. Thus, thebreakout was downward. The day after the announcement, an insiderbought 10,000 shares, spending a cool half million. Even Jake doesn’thave timing that bad. Over time, traders sawed the price of the stockin half.Three months later, in May, the company was at it again, announcing quarterly earnings. The results were better than the consensus estimate, but the balance sheet did not show the kind of growth that Lowe’sexhibited, according to the report. What happened to the stock? Itgapped lower, making a large intraday price swing and closing near thelow. The stock formed a small flag then a descending broadening wedge.Traders hammered the stock down to near 20 in January 2003 (notshown).
Bad Earnings Surprise
195
Identification
Here is what to look for when trying to identify a suitable trading candidate:• The general market and industry should also be trending downward. Does it look like the downtrend will continue? If not,then avoid shorting the stock unless you have good reasons fordoing so.• Look for a falling price trend. Performance improves when youtrade with the trend.• The intraday high-low trading range on the announcement dayshould be taller than the 30-day average high-low range. Thetaller it is, the better. Earnings announcements with swings twoor three times the average height perform much better thanshorter ones.• Price must close below the announcement day low, staging adownward breakout. The stock may bottom in a week and beginrebounding. If it does, close out the trade immediately.
Trading and Trading Tips
This pattern is not for the novice investor. Only experienced tradersshould attempt to short a stock showing a bad earnings surprise. The following trading information may prove useful:• If you trade the stock perfectly, expect an average decline of 13%in a bull market, 17% in a bear market.• It takes about a month for price to reach the ultimate low.• Thirty-one percent of the patterns fail to drop more than 5%.Over half, 51%, fail to drop at least 10%. Those are not goodnumbers so you should be confident of your trading decision.• Forty-seven percent of the patterns in a bull market will reach theultimate low in a week, 48% in a bear market bottom duringweek one.• The best performers have breakouts within a third of the yearlylow.
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196
• Pullbacks happen 41% of the time and when they do occur, performance suffers. Thus, avoid trading event patterns with nearbyunderlying support.• Patterns taller than the median height divided by the breakoutprice of 5.01% perform best.• To get a target price, compute the height (high-low) on the announcement day and subtract it from the low price. Prices hit thetarget 69% of the time.
Case Study
Figure 8.7 shows the setup for this case study. “I bought after the breakaway gap,” Jake said. A breakaway gap occurs upon leaving a consolidation region, usually on high volume. The price gaps upward so thattoday’s close is above yesterday’s high, leaving a blank space on the pricechart. Prices continue rising far enough that the gap does not close for along time. What does that mean? Closing a gap means that price hasHughes Supply Inc. (Retail Building Supply, NYSE, HUG)
A
19
EarningsReleased
181716
SymmetricalTriangle
1514
Bought13
12
Flag11
Sold10
Sep
Oct
Nov
Dec
Jan 03
Feb
Mar
Apr
May
Jun
FIGURE 8.7 Jake bought the breakaway gap and hung on too long,well after bad earnings sent the stock plunging.
9
Good Earnings Surprise
197
declined far enough to cover the gap left on the chart. Just 2% of breakawaygaps close in the first week, 23% close in the first month, 46% withinthree months, and 66% close within a year. That still leaves 34% open.“You bought into a downtrend?” I asked. “Gutsy.”“Yeah,” Jake replied. “I thought it represented a trend change, andfor a while, I was right.”The stock peaked at A and when the company released earnings inNovember, the stock made a lower peak.“You should have sold once the stock made a lower high. Whenprice drops below the valley between them, it confirms a trend change.”“I know that now,” Jake said. He didn’t look happy talking aboutthe trade. I’m sure visions of higher health insurance premiums filteredthrough his consciousness.As Figure 8.7 shows, the stock tumbled after the second earningsannouncement.“When the stock broke out downward from the symmetrical triangle, why didn’t you sell?”He shrugged his shoulders and stared at his shoelaces. Then helooked up. “I sold just two days before the low. Can you believe that?”“Everyone makes mistakes, Jake. The key question is, did you learnfrom your mistake?”“Yeah. I’m not in love with Hughes Supply anymore.”
Good Earnings SurpriseA good earnings announcement sends prices higher, sometimes gappingupward. The bad news is that 29% fail to rise at least 5%, and 48% failto rise at least 10% after the breakout. Thus, only experienced tradersshould trade this one. Nevertheless, it pays to understand what might bewaiting for you each quarter if you own a stock.Figure 8.8 shows an earnings announcement that happened at thevery bottom of a downtrend. The announcement acted as a reversal offortunes. After the news release, the stock moved like a boy kissing a girlfor the first time—a hesitant, shy, sideways move for a few days. A weekafter the announcement, the stock finally broke out upward then movedsideways and formed a symmetrical triangle. After the triangle breakoutoccurred, it was off to the races as price climbed in a measured move upfashion.
EVENT PATTERNS
198
Forest Oil Corp. (Pertroleum (Producing), NYSE, FST)3634
MeasuredMoveUp
323028
EarningsReleased
26242322212019
SymmetricalTriangleBreakout
181716151413
Dec
Jan 00
Feb
Mar
Apr
May
Jun
Jul
Aug
12Sep
FIGURE 8.8 Prices took a week to break out upward after an earningsrelease, and yet the rise was worth waiting for.
Identification
What should you look for when trying to pick good earnings announcements to trade? Here is a list:• Look for a rising price trend. The best performance comes whenyou trade with the prevailing price trend, preferably in a risinggeneral market (bull market with the appropriate index or average trending up).• Trade announcements in a stock in which the industry is also doing well.• On the announcement day or when the stock next trades, lookfor a tall intraday price range or for price to gap upward. The intraday price range should be taller than the 30-day average for thebest performance. Taller is best. A gap shows buying enthusiasm.• Wait for the breakout. That’s a close above the intraday high onthe announcement day.
Good Earnings Surprise
199
Trading and Trading Tips
While researching this event pattern, I found some trading tips thatmight prove useful. Here they are:• Price climbed an average of 24%.• The best performers occur within a third of the yearly low, butthey are rare, happening just 26% of the time.• The worst performers are those in the middle third of the yearlyprice range.• Throwbacks occur 41% of the time but when they do occur, performance suffers. Thus, look for overhead resistance and selectevent patterns with little or no cloud cover.• Forty-one percent of the patterns reach theultimate high in the first week.days toultimate high• Tall patterns perform better than shortor lowones. Tall means the high-low range isthe average timehigher than the median height divided byfrom the dateof the breakoutthe breakout price of 4.57%.to the date of• To get a price target, measure the patternthe ultimate highor low.height and add it to the intraday high onthe announcement day. Prices reach the target 75% of the time.Case Study
Figure 8.9 shows the next case study. The stock made a symmetrical triangle that broke out upward, powered by an earnings announcement.“I bought 400 shares at the market,” Jake said, “filled at 31.75. Iguessed that the triangle would support the price if the trade didn’t workout right. You can see that it did, starting in May.”The price target was a measured move up of 34.09, call it 34. That’sthe measure from the base at 28.54 (A), the close the day before the earnings announcement, to 32, a day later when price peaked, and then projected upward from the low price the day before the buy.“The measure rule worked for the October quarter surprise [targetof 30] and I expected it would work for this one as well,” Jake said.“Downside was the recent low of 28 and change.” That would give a12% loss, which he thought was a bit high.
EVENT PATTERNS
200
Linens N Things (Retail (Special Lines), NYSE, LIN)Sold
3736
Bought
3534
Target
Triangle ApexSupport andResistance
B
3332313029
A
OctoberEarningsRelease
GoodEarnings
28
SymmetricalTriangle
26
27
25242322
03
Nov
Dec
Jan 04
Feb
Mar
Apr
May
Jun
Jul
Aug
21
FIGURE 8.9 A good earnings announcement leads to a profitable trade.The black dots are the locations of stop-loss orders.
“I used a mental stop of 28 at first, just to allow the stock somebreathing room. Then I raised it to 30.84, just below the prior valley (thefirst black dot in February).” A mental stop is one not placed with yourbroker. You monitor the stock and when it hits the price, you sell. Onlyprofessionals should use it because it requires commitment. If price hitsthe stop, you have to sell the stock.The black dots on Figure 8.9 show where and when he placed thestops with his broker. He raised the stop to 32.13 or just below thenearby valley when price peaked. The next day, he raised it to 33.23 afterthe market closed.Did the stop take him out? No. “I sold at the market because theCCI was diverging, the RSI was overbought, the market was down, andthe stock was falling, piercing an up trendline.”The CCI is the commodity channel index, an indicator that showsshort-term trading opportunities. Divergence occurred when the indicatorwas trending down even as the stock climbed from A. RSI is the relative
Earnings Flag
201
strength index and the indicator peaked above 70, overbought. Indicators are beyond the scope of this book, but you can do your own researchand evaluate them on this stock.The S&P 500 made a triple top and was now heading downrapidly. The trendline Jake mentions connects points A and B and projects upward until it pierces price near the high. Collectively, the information told him to sell.“The stock filled at 35.20.” He made $1,350 or almost 11% and hehandily beat the price target of 34.
Earnings FlagIf there is an event pattern to get excited about, it’s this one: an earningsflag. Just 10% of earnings flags fail to climb more than 5% after thebreakout, which is good for an event pattern. The average rise for flags is34%, also good. Both numbers rank one (best) for performance amongevent patterns.Figure 8.10 shows what an earnings flag looks like. Prices easeddown from the broadening top and diamond bottom chart patterns leading to the September valley. Then prices bobbled up and formed an inverted and ascending scallop, bottoming at B. Even before the release ofearnings in early November, the smart money was already in the stock,forcing the price up from the low at B. The earnings news was good as faras the market was concerned, and the stock continued higher until peaking at A. Then it moved sideways in a pennant pattern (shown as theearnings flag AC). An upward breakout from the pennant was the buysignal.Notice that this earnings flag isn’t a flag at all, but a pennant. Thelabel earnings flag is a misnomer as the shape of the flag portion of theevent pattern is often a random collection of squiggles. When the patterntakes the shape of a flag or pennant, then use a close above the top trendline as the buy signal. Otherwise, a close above the flagpole high serves asthe buy signal. In Figure 8.10, the flagpole is the near vertical move fromB to A. If the pennant were squiggles, then a close above A (the highestpeak in the pattern) would be the buy signal.
EVENT PATTERNS
202
Administaff Inc. (Human Resourses, NYSE, ASF)181716
ABroadeningTop
Inverted andAscendingScallop
15
C
14
EarningsFlag
13
EarningsReleased
121110
B
DiamondBottom
9
8
03
Aug
Sep
Oct
Nov
Dec
Jan 04
Feb
Mar
Apr
May
7
FIGURE 8.10 A steep rise precedes an earnings flag.
Identification
Look for the following when selecting an earnings flag:• A large price move the day earnings are announced or the following trading day if the market is closed.• A straight-line price run from the announcement to the flag formsthe flagpole. The median flagpole length is five days.• The flag portion of the pattern can be any shape. Look for prices toconsolidate (move horizontally). It’s an opportunity for traders tocollect their breath, and check their pockets and couch cushionsto see if they can scrape more money together to buy the stock.• Wait for an upward breakout. That occurs when price pierces aflag trendline—or absent a trendline—a close above the high inthe event pattern (usually the flagpole).Perhaps most important of the guidelines is the straight-line pricerun. Like trading regular flags and pennants, a sharp run-up is almostmandatory. The rapid price rise shows unbridled enthusiasm for thestock. After the consolidation ends, the stock resumes the rise. Avoidearnings flags without a near vertical flagpole.
Earnings Flag
203
Trading and Trading Tips
Some trading tips and information that might increase your odds of asuccessful trade include the following:• Most earnings flags are continuation patterns, but reversals perform better (a 38% average rise versus 33% for continuations).• The average climb from the breakout to the ultimate high is 114days (almost four months), so patience is required to capture thefull gain.• The flag width (excluding the flagpole) to the breakout averages18 days.• Most flags appear within a third of the yearly high, but those withina third of the yearly low perform best with rises averaging 48%.• The worst performance comes from breakouts in the middlethird of the yearly price range. Those are the ones to avoid.• Throwbacks occur 63% of the time. When a throwback occurs,performance suffers so avoid patterns with nearby overheadresistance.• Patterns taller than the median height divided by the breakoutprice of 13.56% do better than short ones. Measure the heightfrom the bottom of the flagpole (where the rapid uptrend begins)to the top of the event pattern.• Some patterns top out in the first week so be prepared to takeprofits.• The measure rule predicts a price target. Find the height of thepattern from the base of the flagpole to the top of the pattern andadd the difference to the flag low (the lowest price to the right ofthe flagpole). The result is the target and prices reach the target86% of the time in a bull market.
Case Study
Jake pointed to the screen (see Figure 8.11). “Look at the trade I made.I’m particularly proud of this one.”He bought 500 shares, filled at 20.88, well after the release of earnings and even above the flag itself.“Why so late getting in?”
EVENT PATTERNS
204
Butler Manufacturing (Building Materials, NYSE, BBR)23
Bought
2221
Sold
20
Buyout
19
EarningsFlag
18
17
EarningsReleased16
15
Jul
Aug
Sep
Oct
Nov
Dec
Jan 04
Feb
Mar
Apr
14
FIGURE 8.11 Jake was late buying after the earnings flag appeared, buthis exit was almost perfect.
He shrugged his shoulders. “Better late than never.” He predicted aslow uphill move with a target of 24, perhaps coasting as high as 25 or 26before encountering overhead resistance.If you consider that the base of the flagpole is near 15 and the topof the flag is about 20, that’s a $5 spread. From the flag apex at 19, projected $5 upward, that’s where Jake gets the 24 target. As you can see, thestock fell short of the target. A better target would be to use half theheight projected upward for a closer target of 21.50.The black dots on the chart show the stop locations and the dayswhen he raised the stop. He likes to put his stops just below valleys (tothe left and slightly above each dot).Over the weekend, he reviewed the fundamentals of the companyand didn’t like what he read. “On the weekly chart, the stock peaked during January in four of the last five years. With a profit of almost $1,000and an earnings release coming in February, I wasn’t going to risk holding the stock.”
Stock Downgrades
205
The CCI and RSI indicators were both showing bearish divergencefrom October to December—predicting a downturn in the stock, butboth turned up in January. The RSI was in overbought territory. Thestock was just outside the top of the Bollinger band, a bearish signal eventhough price can slide along the band for days or weeks. Eventually, itwill turn down and bounce off a lower band. The rate of change oscillator said that upward momentum was losing steam—another bearish divergence over the last two months. Jake considered all of those clues tomake a trading decision.He changed the most recent stop order to a market order and thestock sold at the open, filled at 22.88. He made $970 on the trade, or 9%.A few weeks after he sold, the stock received a 22.50 buyout offerfrom BlueScope Steel.
Stock DowngradesFew things are as upsetting as having a brokerage firm downgrade a stockI own and watch it tumble. The startling thing about stock downgradesis that price breaks out upward 39% of the time. What is probably anembarrassment for the people doing the downgrading, 48% issue theirdowngrades when the stock is trading within a third of the yearly low.Just 30% of the 691 downgrades I looked at occurred within a third ofthe yearly high when the warning would do the most good.Figure 8.12 shows a litany of newsworthy items. First, a brokeragefirm upgraded the stock in July. You can see what a great call that onewas. If you followed their advice and bought the stock, you would havelost over 30% in five months. A week after the upgrade, the company announced earnings that missed the consensus estimate, starting price cascading downward like water over Niagara Falls.At point A, a fund told a financial newspaper that the stock couldreach $70 during the next year. The highest price the stock reached during that time was 54.30 (two days after the prediction). In fact, the stockclosed a year later at 45.64, well short of 70.Another poor earnings report sent the stock tumbling in midOctober. In mid-November, the company announced that a new cholesterol drug was showing promise for use in battling heart attacks. Thatsent the stock upward, but only for a few days.
EVENT PATTERNS
206
Merck and Co., Inc. (Drug, NYSE, MRK)
6159
PoorEarnings
5755
AUpgrade
53
DowngradeDrugDevelopmentDiscontinuedPoorEarnings
51504948474645
Scallop
44434241
Downgrade
4039383703
Jul
Aug
Sep
Oct
Nov
Dec
Jan 04
Feb
Mar
Apr
36
FIGURE 8.12 An upgrade occurs near the yearly high and the Novemberdowngrade comes near the yearly low.
Then came word that the company discontinued development of adiabetes drug. The next day, the stock gapped downward when two largebrokerage firms downgraded the stock. The downgrade sounded like agood call, but you can see that it occurred near the yearly low. Clearly,the downgrade would have been much more effective if it happened inJune near 60.Another downgrade came in January as the stock was recovering.Price gapped lower on the news but soon rebounded. The stock roundedover in an inverted and descending scallop chart pattern. After that, andoff the chart to the right, the stock moved horizontally before taking abig nosedive in October 2004 when the company pulled Vioxx from theshelves (see Figure 8.1).Identification
Unless you are a favorite pet of the brokerage firm, you won’t hear abouta downgrade until after it happens. By then, the stock’s price may be
Stock Downgrades
207
gapping downward. If you want to trade a downgrade, here’s what tolook for:• A financial institution (brokerage firm, investment bank, and soon) announces the downgrade.• Look for a large intraday trading range. The larger the better. Itshould be larger than the 30-day average intraday high-low trading range.• A downward breakout occurs when price closes below the announcement day low. A downward breakout occurs 61% of thetime, so that is the direction to trade.• Heavy volume usually accompanies the downgrade.
Trading and Trading Tips
Consider the following trading tips and general information to help youavoid losing money or perhaps make some after a downgrade:• If the breakout is upward, expect the stock to round over andthen decline. An example of this is the January downgrade in Figure 8.12. In 37% of the cases, the stock begins tumbling within aweek after the announcement. Within a month, half have peaked.Wait for the stock to peak and then consider selling a long holding or shorting the stock. The average decline of stocks once theypeak (after a downgrade) is 30% in a bull market (but rememberthat the number is based on perfect trades).• The average rise after an upward breakout is 27%. Downwardbreakouts drop an average of 14% in a bull market, 19% in a bearmarket.• It takes price an average of 79 days to reach the ultimate highafter an upward breakout and 26 days to drop to the ultimate lowafter a downward breakout.• About 25% of the stocks showing an upward or downward breakout fail to move more than 5% in the direction of the breakoutbefore reversing trend. Almost half don’t clear a 10% (downwardbreakouts) or 15% (upward breakouts) hurdle.
EVENT PATTERNS
208
• Both breakout directions do best when the breakout is within athird of the yearly low.• Throwbacks and pullbacks occur 49% and 48% of the time,respectively. Pullbacks hurt performance so avoid trading downgrade announcements with a downward breakout and underlyingsupport.• Tall patterns perform better than short ones. In a bull market, usethe height divided by the breakout price compared to the median5.75%. In a bear market, a tall pattern is one taller than the median 6.52%.• The measure rule works 71% of the time for upward breakoutsand 69% of the time for downward ones. Compute the announcement day height and add/subtract it from the high/lowfor upward/downward breakouts to get a target price.
Case Study
Figure 8.13 shows the next trade. In December, a broker upgraded thestock and prices climbed for two days despite a warning that earningswould not live up to expectations. Then the stock plummeted in astraight-line run. Along the way, the company settled an asbestos relatedlawsuit, but the stock continued down. Three days later, a broker downgraded the stock and it dropped 11% in one day. Two days later, anotherbroker downgraded the stock at the very bottom of its descent.That’s when Jake became interested. After a 36% decline in justeight trading days, he expected a bounce and decided to trade thatbounce. The day the stock moved up, he bought.“The straight-line price decline was key,” he said. “Without that, Iwould have stayed away.”The release of earnings in late January was worse than expected,however the stock moved up sharply on the news. Jake drew a short-termtrendline along the price lows as shown on Figure 8.13. He expected thestock to stall at point A, falling victim to overhead resistance stapled tothe ceiling in October (see the dashed lines). When the stock closed below the trendline, he sold the next day.
Stock Upgrades
209
Dow Chemical (Chemical (Basic), NYSE, DOW)383736353433
SettlesLawsuitA
32
Upgrade
313029
Sold
28
Downgrade
27
EarningsReleased
2625
Downgrade
24
Bought
23222120Oct
Nov
Dec
Jan 02
Feb
Mar
Apr
May
Jun
Jul
19Aug
FIGURE 8.13 Jake bought after prices bottomed and exited when pricespierced a trendline.
Stock UpgradesWhen I first looked at the study results of 698 stock rating upgrades, Ihad to recheck my work. The numbers said that regardless of the breakout direction, prices usually reversed course.Figure 8.14 shows the first example. At the start of the New Year, abroker upgraded the stock and price gapped upward on the news. Itcoasted higher until peaking at point A. Then the buying enthusiasmpowering the stock upward cooled and selling pressure took hold. Thestock dropped, sinking to a low at B.Another broker upgraded the stock the same day as the release ofbetter than expected earnings. Again, the stock gapped upward on thenews but this time, the stock did not make a higher peak. Prices roundedover and then tumbled from 17 and change to below 4 in October 2002,a massive decline of 80%.
EVENT PATTERNS
210
EMC Corporation (Computers & Peripherals, NYSE, EMC)212019
Upgrade
A
1817161514
B
13
Upgrade
12111098
7
01
Sep
Oct
Nov
Dec
Jan 02
Feb
Mar
Apr
May
Jun
6
FIGURE 8.14 After an upward breakout from a rating upgrade, thestock curls over and heads down.
“And to think that there was at least one investor buying the stockat the very peak . . . ” Jake said and stabbed his finger at point A. “I wonder if Trader Joe had the sense to sell before the stock bottomed.”Notice the price pattern in Figure 8.14. A rating upgrade and upward breakout followed by a decline a few days to a few weeks later. Thishooking action is typical of stock upgrades. It doesn’t happen all of thetime. One measure indicates that in a bull market, over half are trendingdownward within three weeks. In a bear market, performance is evenworse with 53% peaking within the first two weeks.Figure 8.15 shows what a downward breakout looks like. A brokerupgraded the stock from neutral to buy in late November. For a week, itlooked like price was going to break out upward, but it never closed abovethe high posted on the announcement day. Instead, prices dropped, eventually closing below the announcement day’s low and staging a downwardbreakout. Then look what happened. Two days later, in a daily pipe bottom at point A—pipe bottoms are more reliable on the weekly scale—thestock closed higher. Over the coming month, the stock continued movingupward, reaching a peak 53% above the low at point A.
Stock Upgrades
211
AmeriTrade A (Securities Brokerage, NASDAQ, AMTD)171615
Upgrade
141312
A
11
Breakout10
9
Sep
Oct
Nov
Dec
Jan 04
Feb
Mar
Apr
May
Jun
8
FIGURE 8.15 An upgrade has a downward breakout but prices soonrebound.
The breakout was downward but price soon moved up and posted