How to Cash In on “Upside Surprise”

By TradeSmith Research Team

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Big U.S. banks kicked earnings season off Friday.

And they kicked it off strong — so strong that the shares of all the major banks surged at the opening bell.

But the biggest gains may be weeks, even months down the road.

Here’s what I mean…

Sometimes, especially with large-cap blue-chip, those immediate post-earnings moves can be tame — or even tepid.

JPMorgan, Citibank, and Wells Fargo all surged about 3% in early Friday trading. That’s despite topping estimates and, in some cases, raising their forward guidance.

Single-digit moves like that aren’t exactly fortune makers. And you would’ve had to own the stocks beforehand to pocket them.

Even under the best of circumstances, earnings are notoriously tough to predict — even if you have an edge (which we’ll discuss in a bit).

Me though? In this circumstance, I’m not especially focused on these near-term moves.

I’m looking out through the end of the year to see the real impact of these positive reports… as I will be for any other stock that beats on estimates (an “upside surprise” in Wall Street parlance).

That brings me back to that “edge”…

There’s a little-talked-about market phenomenon that’s greatly predictive of stock-price gains. And this phenomenon suggests the big bank moves on Friday are merely a buy signal that could take all of them much higher.

I’ll share what I know about this effect today. And I’ll give you a trading plan so you can capitalize yourself…

The Post-Earnings Announcement Drift

Funny thing about earnings announcements…

They entice traders to place bets before the reports, despite there being so little certainty of how they’ll play out.

But there’s been a long-observed market phenomenon that shows up after companies beat on their earnings estimates.

These “upside surprise” stocks show a substantial upward bias over the weeks and months that follow — and even buck the broad market trend.

This is called the post-earnings-announcement drift. It was first observed in the late ‘60s by economic researchers Ray J. Ball and Phillip Brown.

And what it essentially tells us is that we don’t need to trade before earnings to make great gains. We can just as easily trade after, once the dust has settled… and take advantage of a longer move that’ll take the stocks even higher.

This can’t always be chalked up to broad market trends, either. Want proof? Just look at a few stocks that showed this effect during last year’s bear market.

  • ExxonMobil (XOM): ExxonMobil beat earnings expectations on July 29, 2022, and its stock price rose by 8% in the following week.
    • Two months later, the stock was up 12% from its earnings report.
  • JPMorgan Chase (JPM): JPMorgan Chase beat earnings expectations on Jan. 14, 2022, and its shares rose 5% in the following week.
    • By March, after Russia’s invasion of Ukraine, JPM was up 8%.
  • Home Depot (HD): Home Depot beat earnings expectations on Feb. 21, 2022, and its stock rose 4% in the week that followed.
    • Another two months later, the stock was up 6% in total.
Against that bear-market backdrop — when most stocks and sectors traded lower — these stocks showed real muscle after positive earnings reports.

Fast-forward to the present — with its unique storyline of inflation, interest-rate headwinds and debates about the economy’s health — how can we put this “edge” to use?

A Different Earnings Trade Plan

We’re already set up to see a strong close for 2023. Seasonal trends point to the months between October and January to be some of the most bullish in the year.

At the same time, we’re seeing “earnings beats” from some titans of the financial sector. And a ton of companies from the tech sector are set to report earnings this week.

One way to leverage a potential post-earnings drift is to buy at-the-money or near-the-money call options set to expire early next year on stocks that beat on their earnings estimates. That would help us leverage the post-earnings move and give us plenty of time for the trade to play out.

One example: The JPM $160 call option expiring on Jan. 24 is trading at about $2.51 as I write on Friday. If JPM rises to $161 per share by the first week of December, that’ll deliver a 100% gain on the value of the call option.

That’s a gain of about 11% in JPM stock in 10 weeks — a totally feasible return given JPM’s big earnings beat and seasonal forces heading into the holidays.

If you do plan to make a trade like this, just be sure to risk only what you can afford to lose and apply proper risk management. If you subscribe to TradeStops, you can use the Volatility Quotient metric to determine a good level to cut losses should the trade turn against you.

Of course, that’s not to say there’s no money to be made trading before earnings reports, either…