10 Percent Gains Guaranteed, But With A Catch

Long term success in a dealing room, and in trading and investing outside that environment as well, depends on many things. Perhaps the most important is avoiding the big, blow-out loss, or at least minimizing the risk of that occurrence. That is why I am not generally a fan of running a short term stock position through earnings releases. Any big surprise in the numbers or untoward comment in an ensuing press conference or conference call can initiate a big move with a huge gap in liquidity. That negates any sensible precautions taken to control risk through stop losses and leaves you with an unenviable decision to make…cut for a big loss or hold on and hope.

The volatility around earnings season, though, equates to enormous opportunity.

The challenge, therefore, is how can you take advantage of that without risking long term success? The answer lies in trading the market's expectations for earnings, rather than the earning's themselves. Sentiment around a stock will often be the same going into numbers repeatedly, regardless of past results. Solar City (SCTY) would be a good example.

The company is probably best known as part of the Elon Musk Empire. Musk, the man behind Tesla (TSLA) and SpaceX and the co-founder of PayPal is Chairman of the company, which is America's leading provider of solar power systems to individual and commercial customers. Now it so happens that I believe that that position makes SCTY a good long term investment, especially as Tesla's home battery system is developed and deployed. Along with that comes the tantalizing prospect of some kind of proprietary connection between the two systems and the resulting boost to Solar City's prospects.

Those long term prospects are not the point here, but Musk's involvement in the company is relevant. He is the darling of a certain section of Wall Street, which has inordinate faith in his ability to perform miracles. That is why, despite never having made any money thus far, the stock tends to outperform in the run up to earnings. As it happens, February's release showed a bad miss and the stock collapsed, whereas SCTY reported a less than expected loss in May and the stock initially climbed. That shows the unpredictability of earnings and the reason to focus on the run-up, not the event. The chart below, with the earnings release marked by the red arrows, demonstrates the point.

The post earnings performance, though interesting, is not relevant. What is is that the stock has shown gains of over 10 percent immediately before each of the last two releases. Calendar Q2 earnings for Solar City will be reported next Thursday, July 29th, so buying now in anticipation of a repeat performance is an obvious strategy, and in this case there is nothing wrong with the obvious.

Even though you are looking for a short term pop in the run up to earnings here it could be that, when that comes, you would be tempted to hold on through the actual release. After all, you would have a decent cushion to guard against a bad result, and that could serve to make the risk worthwhile. The problem inherent in that though is that the fast money that has bought in anticipation of a good result will be looking for an exit. That makes a weak reaction to a positive surprise a distinct possibility, and that risk that must be added to the risk of Musk delivering bad news. On balance, keeping this a short term trade is preferable.

Wall Street traders, like all of us, are creatures of habit. If they have done something before and made money, it is reasonable to assume that they will do the same thing again. Buyers have emerged in the week or so before SCTY's earnings in each of the last two quarters and those buyers showed a profit. Betting that they will again provides an opportunity to benefit from earnings season volatility, while not exposing yourself to the risk of a calamitous short term loss by holding a position through the news.