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How to Tell When Bad News is Bad

How to Tell When Bad News is Bad

Traders follow the news closely. Some make buy and sell decisions based solely on headlines. Others have programmed computers to read the news and place a trade before human eyes have had time to even read the headline. Still others take a slower approach and trade the reaction to the news.

As individual investors, we need to understand our limitations. It’s not possible for most of us to create algorithms that can read the news story and trade based on the tone of the article. Most of us simply don’t have the ability to write computer programs like that.

Even if you have the ability to write that program, you probably don’t have access to computer systems that are fast enough to trade the news ahead of Wall Street firms. The firms that trade news tend to use high speed data lines that connect them to news feeds, exchange data systems and order entry screens.

For that type of trading, time is measured in nanoseconds. Holding periods, the time between opening and closing a position, can be less than the amount of time it takes to blink your eye. As individuals, we cannot compete in that environment.

We can, however, find a profitable edge in making trading decisions based on the reaction to the news.

Sometimes, Bad News is Good News and Sometimes It’s Bad News

If you spend any time at all reading financial news, you quickly notice headline writers seem to be making things up as they go along. For example, they will have to write headlines about the unemployment report every month and their headline seems to be largely a reaction to the news.

We know in advance when that news is coming. It will usually be on the first Friday of the month unless a holiday interferes with that schedule. The report comes out at 8:30 eastern time and the stock market opens an hour later. No matter what stocks do, the headline is that the data caused the move.

If the report is good and stocks are up, the headline points to optimism related to an improving economy. If the report is good and stocks are down, the headline explains traders are worried about an overheating economy and the prospect of inflation.

If the report is bad and stocks are down, the headline says traders understand times are bad. If the report is bad and stocks are up, the story is that the stock market is forward looking and sees good times ahead.

That’s it. Those are the possible outcomes and the possible stories. Anything can happen on the day the report is announced. The market’s reaction might be the most important story of the day. That tells us what traders are thinking, because in the market traders turn thoughts into actions.

If traders shrug off bad news, they are pessimistic and we should explain more declines. A market reaction showing optimism is bullish for the market. Individual investors can interpret reactions and that can help them find an edge in trading.

Earnings Provide an Indication of Future Expectations

For individual stocks, earnings announcements are among the most important news events a company will make. The date of the report is known in advance. Traders are usually watching for the news and they respond quickly. We often see large price moves that tell us what to expect in the future.

On Thursday, after the close, National Beverage Corp. (Nasdaq: FIZZ) announced earnings. The company reported earnings per share (EPS) of $0.82 for the quarter, beating analysts’ consensus estimates of $0.74.

National Beverage sells a portfolio of flavored beverage products in North America and internationally. The company offers beverages to the active and health-conscious consumers, including sparkling waters under the LaCroix, LaCroix Cúrate, LaCroix NiCola, and Shasta Sparkling Water brand names; energy drinks and shots under the Rip It brand name; juice and juice-based products under the Everfresh, Everfresh Premier Varietals, and Mr. Pure brand names; and carbonated soft drinks under the Shasta and Faygo brands.

These are everyday products with relatively low prices. National Beverage has been successful largely because it has been able to reduce costs. In 2011, the company’s total operating expenses accounted for 89.6% of its revenue. Over the past twelve months, this ratio has been reduced to 80.3%.

Reducing expenses has allowed the company to increase EPS faster than revenue has been growing. This has helped the stock become a top performer.

The stock has gained nearly 600% since the summer of 2014, a little more than three years. Over that time, EPS grew at an average of 35% a year while sales grew by 9%.

Gauging the Market’s Reaction to the News

We know that traders have been generally impressed with National Beverage’s operating results. We know this simply from the fact that the stock has gone up so much in the past three years.

We also know that, on average, traders respond favorably to earnings reports. In part, this is due to the fact that the company has a history of beating earnings expectations. On average, National Beverage beats expectations by 9.2% and the stock gains 6.9% over the next week.

The most recent earnings reports beat expectations by 10.2%, a little better than average. But, the initial market response was negative with the stock falling as much as 8.5% in the first half hour of trading as the intraday chart below shows.

Selling is an indication of profit taking. The rapid rebound is an indication that investors came into the market. They may have been waiting for the chance to buy the stock on a pullback and they rushed in, fearing the pullback would be short lived.

A Trading Strategy for the Stock

It’s likely FIZZ will continue to rally as traders assess the bullish reaction to the earnings news. To benefit from potential gains in FIZZ, an investor could buy shares of the company. This requires a significant amount of capital and exposes the investor to standard risks of owning a stock.

To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options.

To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call.

This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.

Source: The Options Industry Council

Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.

For FIZZ, the September 15 $120 call option can be bought for about $2.90 and the September 15 $125 call could be sold for about $1.00. This trade would cost $190 to open since each contract covers 100 shares of stock.

The potential gain is $310, a potential gain of more than 60% on the amount of capital risked. This is a trade that will last just one week, offering a large potential reward for a short amount of time.