Question about protecting yourself from company not beating earning estimate

Question

I'm new to this site and thought I'd start off with a quick question. Let's use Advance Auto Parts (AAP) in my example.

Let's assume you are looking into buying AAP and you do all the research you can, financial statements look good, you think to yourself people might be fixing their cars instead of buying new ones because of the economy, AAP has beaten their estimates(except one time on 5/18/2011), their ratios look better then their competitors and no red flags in general.

So you decide to buy 1000 shares of AAP for $75 a share on 1/24/2012. You start riding the gravy train and notice AAP reports their earnings before the market opens on 5/17/2012 so you check them out once they're announced. You notice they didn't beat their earnings and decide just to sell once the market opens and cash in your profit.

To your surprise AAP stock dropped from $82.10 when it closed on 5/16/2012 to 72.28 on the open (11% drop) and your investment went from $7,100 gain to a 2,720 loss.

So my general question how to avoid a case like this? Do you normally get a feeling when a company doesn't make their estimates a few days before? Like starting to see news articles about the company not going to make their estimates?

Just wondering because I just started investing for the first time and AAP was the first stock I bought because it appears undervalued. However during my research I did notice 11% drop when they missed their estimates.

Answer 1

The best thing to do to avoid this is not to sell as you've described. What purpose does it solve? If you're speculating, set a price at which you want to cash out and put a limit order. If you're a long term investor, then unless something fundamental has changed - why would you sell?

Answer 2

You could do what littleadv said above but there are also other methods to protect yourself which could be more beneficial.

Firstly, addressing you point about sort of a gut feeling or reading articles about predicting if a company is going to beat earnings or not, earnings is simply an estimate made by some "educated" analysts. Anyone who can make more accurate predictions frequently would get picked up by one of the massive hedge funds (think Citadel, Ren Tech, Appaloosa, etc.)

Second, you can hedge out much of your risk using put options. Taking your example, lets say you think the stock will go to $90 but you aren't sure. You can buy 10 put options with a strike price of $78. Granted these put options will cost you money and eat into your profits but they protect you on the downside. If the stock shoots up to $90 as you predicted, the put option will expire worthless but you will have made money anyway. If the stock drops below $78 like in you example, then instead of having to sell at $72, you can sell at $78. Something to keep in mind is that short term options around earnings time are super volatile and price highly based on the fact that the stock is likely to make a large/larger move after earnings.

Answer 3

You should never play earnings in the short-term. It's usually a coin toss because you never know how the market will react.

If you were a short-term trader, you could sell your position before earnings. You would have made a 20% profit in a few months.

If you were a longer term investor, that type of price movement would be irrelevant noise. It helps that we can look at this question 7 years later. The stock returned to its pre-earnings price about a year and a half after the gap down you referenced. Today, the stock is worth nearly double what it was in January of 2012.

If you were a long-term investor with a low risk threshold, you could put a stop order in place - maybe something like 5%. You would need to set up a special order to sell after hours to avoid selling into the gap down.

Lastly, as Gerold said, you could hedge your position with put options. The feasibility of this is dependent on your investing timeframe. If you plan to hold for 5+ years, it could get costly to buy put protection during every earnings report. Of course, you could buy far out of the money puts for cheaper, but that would limit your downside protection.

In my opinion, the best plan is to have a timeframe for the trade/investment and a planned stop loss to limit your downside risk.