Why Great Companies Can Dump on Solid Earnings

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Nothing conjures the amount of outrage and sheer frustration from retail traders than a company that smashes earnings and the adjoining security dumps anyway. I must have been asked over a thousand times, and that’s no exaggeration, “Why the hell does a company that reports outstanding earnings dump at market open!!??” I have grown so tired of answering this question that I figured I would write about it so as to just point them to this entry the next time it happens … which will likely be tomorrow, and the day after, and the day after.

Before we get to that however I must point out that for all the forthcoming reasons I rarely play earnings with a full deck … meaning if I play earnings at all, its with roughly 25% of the position I started out with. Of course, that assumes I already have a profit. If I don’t have an established profit I will likely hold through, but then again, I’ve rarely had earnings turn very hard against me after a solid dip. One thing is for certain, … I NEVER play naked calls or naked puts through earnings. The IV (Implied Volatility) Crush alone is usually enough to make even the winning side worthless. But that’s another situation altogether and explaining it would deviate so far off the topic of this piece that it would distract from the overall point I’m trying to get across.

So, we’ve all been there … a company reports earnings, folks place their bets, earnings are released, and the stock does the exact opposite of what the earnings indicated. In some cases, earnings are reported after trading hours (AH) and the companies adjoining security either dumps immediately, or pumps only to dump at market open the following day. In other cases, earnings are announced pre-market, and they either dump immediately, or pumps before dumping at market open. Fairly soon all the momentum is sucked out of the stock and we have a bunch of angry retail traders on our hands. Soon after we see a bunch of analysts on CNBC who are conjuring up reasons as to why the security dumped that are usually so horribly incorrect that I cringe when I witness it. So what gives? I have 9 different reasons why a security dumps after a company reports outstanding earnings. With so many reasons, and these are just a few, you now know why I’m tired of explaining it.

Blame the Options: Few retail traders have given thought to how options affect the market. When you buy a call the institution that sold you the security usually covers the sale with shares. When you buy a put the institution goes short. In this scenario, assuming they sell an equal amount of calls and puts with an equal sized long and short position, the institution profits off the options premium 100% of the time. Not too shabby huh? The issue that comes into play with so many short-term options gamblers in a particular security is when retail eventually takes profit on market open the following day, the options writers can purchase the calls back and sell the shares they used to cover creating a great amount of selling pressure. It’s in their interest to do so as they will likely scoop up some shares on the future dip. If you think this doesn’t happen think about how purchasing options affected the infamous WallStreetBets GME pump a few weeks ago.

Profit Takageddon: You may be holding out for a larger pump after the company smashed earnings, but institutions that own millions to billions of dollars’ worth of shares may be looking to take a large amount of profit off the table. Certainly, they could have sold before earnings, but selling so many shares on low volume would have limited the amount they could have profited. They could have also waited for the price to increase after earnings, but once again the amount of shares they want to depart with usually exceeds the amount normal volume will allow. Additionally, they don’t want to risk other institutions doing what I’m about to tell you next. … … So when is the best time to dump your position of many billions? When volume is the highest of course …. Earnings! You may think you’re a slick trader but the institutions see retail traders as the idiots that provide them the liquidity to dump their shares on. And let’s face it, retail falls for this every time!

Already Priced in: If you are in an overvalued security that pumped hard before earnings would you wait to sell well after earnings when the volume dries up, traders realize the security is overpriced, and it dips? Well it doesn’t really matter what you do does it? Institutions will sell overvalued securities on good earnings whereas the expected beat is already priced in, or perhaps, more than priced in. They’ll do it for no other reason than fear the security has pumped too much. They want to beat the competition to the punch.

A Larger Beat Expected: There are many stocks that just can’t live up to the hype. A company may have beat previous years EPS or revenue by 100% YoY (Year over Year), and suddenly they only beat previous years EPS or revenue by 33%. Sure they’re still growing, however they are growing at a slower rate while the securities value was growing under the assumption that the company would maintain that 100% YoY growth, or perhaps more. This can often lead to a lack of confidence in the current value of the security and lead to selling. The retail trader will complain and ask why the stock dumped a great 33% beat. The answer is simple, everyone was expecting massive growth, … not great growth, not good growth, … but massive growth. In short, massive growth was priced in, and all you got was “petty” great growth. Imagine the outrage!

Future Economic Conditions: Retail traders rarely think beyond immediate circumstances. Perhaps a company beats earnings expectations, raises guidance, but the economic analysts expect the future prospects for the industry to decline. When Disney (DIS) reported outstanding earnings in early 2020 when COVID-19 was still largely contained in China, their stock plummeted all the same. Why? Because DIS may not have factored in COVID into their risk factors or outlook, they certainly didn’t notify their shareholders of such a risk, but the analysts working for institutions nevertheless were. I know I did. It was the most epic short of my mediocre retail trading lifetime.

Temporary Economic Conditions: Some industries are seasonal, political, or cyclical. Some can boom with one political party in power and suffer when the opposition gains power. Gun sales, for example, typically increase when a Democrat is in office. The idea is that a Democrat is more likely than a Republican to advocate for restricting certain firearms, and thus, firearms consumers and collectors rush to purchase them while they still can. The housing market does great under conditions of low Federal Reserve interest rates and in the peak Spring and Summer months. But when the Fed increases rates and the weather cools the housing market isn’t as profitable. In many cases institutions that expect the boom in a certain industry to only be temporary, will lighten their load around earnings time when the volume and liquidity is the highest. Retail rarely sees it coming.

Poor Guidance: The most inexperienced retail traders aren’t aware that earnings, in many cases, are reported in twos. You will often get the preliminary results the night before or morning of, and the earnings call itself can happen the morning or evening after. The devil in all the details, the guidance particularly, is often announced in the earnings call. You could have a situation where a company announced excellent earnings the night before but reported poor future guidance the morning after. Listen to the earnings call if you’re hanging around folks! If you’re reading the earnings transcript its too late.

Maxed out Growth: There are some highly conservative companies out there that aren’t that interested in growth. The firearm manufacturer, Ruger (RGR), is among them. Sure, the gun industry is booming right now but they can only produce so much at max capacity. And perhaps claiming they’re “not interested in growth” is unfair. Because they are, but they’re rather interested in safe sustainable growth. Nevertheless, the industry may be booming but there is only so much money they can make from a backlog and so much traders can price in. After all they’re running at max capacity! Unless they build another facility, buy out another company (they recently acquired Marlin Firearms), or find some space for some more equipment, they can only grow so much. And RGR isn’t the type of company to hire temp workers, but rather workers that they can invest in and make careerists out of. So what will happen upon earnings when volume and liquidity are the highest and some institutions get cold feet as to their confidence in RGR to profit more than they did the quarter twelve months ago? You guessed it. Possible Selling! The retail trader assumes constant growth. The institutional investor considers a business’s capacity to grow … and to grow at a certain rate. If the stock is growing too much as compared the actual company’s growth a correction, no matter what the earnings produce, may be in order. (Note: Do not use this simplistic scenario to make assumptions on RGR)

Stoploss-apalooza: This is more of an earnings dump enhancer than it is anything else but stop losses don’t help. Once a bunch of stop losses on large orders get triggered at a certain point its all down hill from there. Remember a sharp high-volume instance of sustained selling can move a stock price quicker and further than a prolonged instance of moderate to low volume buying. At the end of the day its those who trade the security who determine the price and if the majority of the folks who wish to trade the shares during earnings are intent on taking profit at the same time the morning after they can wreak havoc on the share price.

Folks … rarely is a market dump on outstanding earnings a result of just one of these scenarios. More often than not its a number of these events happening all at once. All things being equal you may now ignore the analysts excuses on CNBC. And it’s the unpredictable scenarios like these that lead me to play earnings with but 25% of my original position IF, and only IF, I am bullish, and never with options! I hope many of you found this entertaining and instructive. Please share this with your friends who are surprised when they think they won an earnings bet only to realize they lost miserably. God Bless and Safe Trading!

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IMPORTANT DISCLAIMER: I am NOT a registered investment adviser, broker dealer, or member of any other association for research providers in any jurisdiction whatsoever and I am NOT qualified to give financial advice. Investing/Trading in securities, particularly microcap securities, is highly speculative and carries an extremely high degree of risk. The information, analysis, and opinions listed above are my own and may not properly reflect the underlying conditions of a company or security. You should do your own Due Diligence. If you trade based on anything I have written YOU ACCEPT FULL RESPONSIBILITY AND LIABILITY for your own trades and actions and hold the author of this publication harmless. If that isn’t clear enough DO NOT TRADE, ACT, OR INVEST, BASED UPON ANYTHING I WRITE OR RECOMMEND. There, we should be solid now.

1 Comments on “Why Great Companies Can Dump on Solid Earnings”

  1. Awesome! thanks for sharing. Retail traders are suckers basically. Love it. Now I know to be carefully, I have made a habit of taking profits a couple of days or day before earnings. I don’t wait to find out how things went.

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