A Contrarian Strategy For Those With Healthy Risk Appetite

Next week is a huge one for energy investors in terms of earnings. Four of the largest multinational integrated oil firms will reveal earnings for the third calendar quarter, beginning with BP (BP) on Tuesday. Conoco Phillips (COP) will then report on Thursday, closely followed by Exxon Mobil (XOM) and Chevron (CVX), both on Friday. It is no great revelation to say that the news is likely to be bad in a comparative sense. Oil closed the last quarter at $45.35, as compared to the third quarter last year when it was at $103.70 on September 30th, or the close of the second quarter, which was $59.10.

Given that, relating the last quarter's performance to historical numbers for any of the big four will be a pointless exercise. What matters to most people is how the companies perform relative to analysts' consensus estimates, and they will be looking for results that are "not as bad as it could have been" or for positive, or at least less negative, guidance from the big four.

For those invested for the long term, of course, one quarter's earnings are not the point. They are counting on a recovery in oil prices and thus in profitability for these companies, over time. Those of us with a shorter term trader's view, however, see the volatility that usually accompanies earnings as an opportunity. In order to take advantage of that opportunity, my advice would usually be to do what I was trained to do in the dealing room; square up before the numbers and then look for exaggerated moves that are likely to rebound. This time, however, is different.

Because of the disparity in forecasts for the oil companies' earnings next week, there may be another way to approach the releases. When there is a lack of consensus about upcoming data, financial markets have a tendency to generate rumors and the so called "whisper number" takes on exaggerated importance. Of course, in reality those whisper numbers are no more than a guess and have little chance of being correct. In a market starved for direction, however, they give some traders the feeling of an edge and that is enough to make them relevant.

I have no idea what the whisper numbers are for the big four next week, nor do I really care. What I care about is that there is one and that its presence produces a move before the earnings release. That doesn't always happen, but when it does it sets up for a trade that is profitable more often than not.

The idea is to trade in the opposite direction to the momentum going into an earnings release. Like anything, it doesn't always work, but it does so more than most would think.

The chart above, for example, is for Chevron (CVX) with the vertical blue lines representing earnings releases. As you can see, in all cases the movement after earnings is in the opposite direction to that in the few days prior. The same pattern can be observed two out of three times each for BP, XOM and COP. In other words the pattern has repeated for 9 of the last 12 earnings releases from the big four oil companies. I don't know about you, but I will take a trade with a 75% chance of success anytime.

What makes this strategy particularly appealing is that when it doesn't work it rarely results in big losses. From a logical perspective that should come as no surprise. If traders have, say, bought a stock in the expectation of an earnings beat and that beat comes, then there are fewer buyers around to react to the news. If anything, there are some potential sellers looking to take a profit which limits the reaction. If, on the other hand, the whisper number is wrong and earnings miss expectations there are a lot of people looking to unload, which increases the downward pressure on the stock.

It should, of course, be stressed that although the market positioning will often limit the damage when you trade in the opposite direction to a pre-earnings move, the strategy still involves running a position through a data release, and as such is inherently risky. If there is a major surprise or announcement accompanying the earnings then liquidity will disappear. That would make stop losses effectively useless and could result in steep losses. As with any contrarian strategy it is meant for those with a trader's mindset and a healthy risk appetite.

That said, though, the opposite can also be true. Positions that are in profit can frequently be run for a while as momentum in the new direction builds. That, and the recent 75% success rate with big oil companies, makes it an attractive trade for earnings next week.