Earnings Spike Potential Algorithm v1.1

First there was the VWSI, now it seems like I am going to try to get ESPA (Earnings Spike Potential Algorithm) off the ground. This immediately raises the question: just how many ugly acronyms should I try to prop up in this space? Maybe I should just do it the way the rest of the world does and start with the acronym I want, then reverse engineer the full text.

Never one to leave well enough alone, I have taken my CNBC Million Dollar Portfolio Challenge (remember that disaster?) cardboard and duct tape version of the ESPA and tweaked it a little for the current earnings season. The changes are not that major and consist largely of beefing up some TA inputs having to do with support and resistance. The resulting ESPA v1.1 seems to do a better job of predicting the magnitude of the post-earnings move and a noticeably better job of picking the direction of that move (which was previously just a little above 50%.)

Armed with a better mousetrap, I will be more active in earnings plays this quarter than usual, using the model to be both long and short straddles and strangles, as well as playing some instances where I have directional bias with straight calls/puts or call/put backspreads.

I do not intend to clutter up with space with a flood of predictions or comments on individual stocks, though I may highlight one or two from time to time. Still, looking at some of the earnings spiker candidates for AMC today through BMO tomorrow, I was struck by the sheer number of stocks with a very high short squeeze potential and a high implied volatility, two ingredients that can help turn a couple of sparks into a widespread conflagration.

Stepping back a little, my thinking is that most of the recent market action has been of the healthy correction variety – the controlled burn that renews instead of destroys. I also think that much of the bearish sentiment we find rolled into an 18ish VIX is of the bullish contrarian variety. As far as I can tell, the big fears are on the table and in the headlines. I suspect that it will require something new and unanticipated to give us the type of conflagration where we could see something like the VIX of 25-30 referenced by Jim Kingsland.

Implied Volatility and Earnings Spikers

A reader asked for some more details about how I use implied volatility (IV) and/or historical volatility to help identify companies with a high potential to spike following an earnings announcement. Specifically, she was looking at the 17% gains in Schnitzer Steel (SCHN) today and wondering if IV could have tipped her off to the probability of a big move.

Regular readers will probably recall that I beat the earnings spiker horse rather severely during the ill-fated (more on their part than mine) CNBC Million Dollar Portfolio Challenge, but for anyone who is interested in some details, I laid out the bulk of my thinking in “How to Find the Spiker Before the Earnings Announcement.”

Since part of the query touched on why I thought IV was better than beta for determining volatility (past and future), here are three reasons why I think IV is superior to beta:

• Yahoo Finance, Google Finance, and other data providers sometimes list betas of 1.0 for issues they apparently have not calculated a beta for, particularly newer issues and foreign stocks
• highly volatile stocks that go in the opposite direction of the market for awhile can sometimes have low betas -- think small oil/gas exploration companies, gold miners, etc., but also consider that some tech stocks may countertrend for a long period and thus acquire a smaller beta than their volatility would suggest (historical volatility would be a better number to watch here, because it focuses entirely on the magnitude of the moves and does not care whether these moves are correlated to the broader markets)
• implied volatility is forward looking, so it automatically adjusts to account for scheduled earnings announcements, a pending FDA drug decision, a legal issue that is due to be resolved, buyout rumors, terrorism, violence in the Middle East, a hurricane that is bearing down on the US, etc.

Getting to the meat of the question, since I am looking forward in time to earnings, I pretty much ignore historical volatility and focus entirely on IV. I usually try to target the top 10% or so most volatile companies that are due to report in a 24 hour period, so that if it is mid-June and there are very few reports, I might look at IV as low as 35 (I generally consider 40 to be a minimum IV), but by the end of July to early August earnings peak, there will be so many small and extremely volatile companies reporting that it might be possible to screen out all companies with an IV below 50. Also, once you get over about 60 or so, I am not sure that a higher IV really translates to incremental future volatility in the short-term (unless we stray from earnings and talk about FDA decisions, etc.)

Regarding specific numbers, I use the current IV Index call number (the 44.20% from the SCHN iVolatility link), but the current IV Index put and current IV Index mean are usually so closely correlated that it doesn't matter which one you pick -- as long as it is a current number.

I also recommend that readers consider looking not just at the raw numbers but also at the 12 month volatility charts (such as this iVolatility chart for SCHN) where it is often much easier to visualize the size of the current pre-earnings volatility run-up – and also compare it to similar up-trending volatility patterns that preceded earnings in the past few quarters. In the case of SCHN, you can see a big jump in volatility during the past week and a sustained move since about mid-April. Implied volatility may not have been screaming “Buy!” in an unambiguous manner, but one can reasonably argue that at an 11 month high just prior to this morning’s earnings announcement, it was warning of the increased possibility of a big move in one direction or the other.

Finally, I would be would be remiss in not reiterating that directional earnings plays are highly speculative and usually carry a formidable risk/reward profile, so I recommend that anyone who plays the earnings lottery considers limiting their exposure with an options play or by making a bet on volatility instead of direction, as volatility typically – and much more predictably – decreases 15-20% the day after earnings are announced.

Put to Call Ratios for Individual Stocks

Today the CXO Advisory Blog is out with an assessment of the predictive value of put to call ratios for individual stocks. Drawing heavily on Jun Pan and Allen Poteshman’s 2006 “The Information in Option Volume for Future Stock Prices” from The Review of Financial Studies, the folks at CXO conclude that put to call ratios have “significant predictive power for individual stocks.” Unfortunately, there is a qualifier that “this effect relates predominantly to data that is not publicly available.” [underline in original]

While I support these conclusions, I would not be so quick to be deterred by the qualifier. In “How to Find the Earnings Spiker Before the Announcement” I highlighted the put to call ratio for individual stocks as a key component of the screening formula and provided a link to the SchaeffersResearch.com page where you can find the appropriate charts and data. This data is both public and free; you can’t beat that.

There is also a subscription service from the ISE called ISEE Select that the exchange describes as a “trading tool that uses proprietary call/put trade data from the ISE to identify bullish and bearish sentiment for individual securities.” The ISE goes on to explain that ISEE Select “allows subscribers to retrieve intraday and historical call/put values for securities whose options are traded on ISE.” For the record, I intend to give ISEE Select a try shortly and will be glad to provide my thoughts about the value of this service in this space. In the interim, interested parties may want to check out ISEE Select services and pricing, as well as their FAQs.

CNBC Loser’s Bracket:: #1056 (Top 1%)

For those who may be interested, the CNBC Million Dollar Portfolio Challenge is winding down this week, with 20 top performers duking it out for $1 million paid out over many years through an IV drip, while the Second Chance Showdown contestants get another shot at glory in the loser’s bracket – with a Sony home entertainment system as a consolation prize to the winner.

I never had a chance to properly chronicle the true extent of my rise and fall in the first round of this contest, as CNBC wiped away the details before I do a proper post-mortem. All I know is that after peaking at the top 0.08%, I fell down to about the top 11%, finally finishing something like 200,000^th, perhaps even lower.

The good news is that the contest gave me an opportunity to test some ideas about how to find stock that were about to make a significant move. Since the end of the contest fell in the middle of earnings season, I focused on companies that were due to report in the next 24 hours and published the details of my formula and some associated free public information sources in “How to Find the Spiker Before the Earnings Announcement” on May 9^th. Recently, I went back and evaluated the 16 companies that I invested in as a result of that earnings spiker formula and discovered that the minimum next day move for those companies was 1.5%, while the maximum move was 30.2% (down in this case), with a mean move of 5.6% and a median move of 3.7% – all of which is based on a one day holding period.

Armed with this information, I thought I should put the same formula to work again in the loser’s bracket. Once again it has been successful, with my last four picks being a 3.0% gain in PETM, a 7.7% gain in FMCN, a 5.3% gain in TSL, and a 3.0% gain in SNDA. The bottom line is that this performance has put me in the top 1% of the current contest at #1056.

Before I start patting myself on the back, however, it looks like I may have shot myself in the foot. Shanghai-based Shanda Entertainment was a solid earnings pick and turned in a very strong quarter, but it appears I was foiled by my own Lost in Translation moment and accidentally sold prior to earnings. To make matters worse, I jumped from the Shanda rocked onto GameStop (GME), whose doubling of revenues was offset by lukewarm guidance. I got my volatility again, but GME is currently trading down 3.6% on the day.

How to Find the Spiker Before the Earnings Announcement

Several readers have expressed interest in how I came up with my earnings spike potential algorithm. Essentially, this is something that has evolved over the past three weeks as a result of my desire to find companies with a high probability of making a substantial near-term move and give my CNBC Million Dollar Portfolio Challenge portfolio a chance to make a run at the finals. To make a long story short, I got the volatility I wanted, but I didn’t always get the direction right.

I would not call this a battle-tested formula. It is more like a hypothesis that continues to evolve as I get more data and continue to test and tune some of the elements. Think of it as just-in-time sausage making.

I am not an arsonist (I even missed out on youthful pyromania), but I liken this task to understanding how to get a fire started and make sure it quickly builds in intensity and spreads as rapidly as possible. For a fire, you need a starter and an accelerant; for an earnings spike, it’s essentially the same thing.

In the links below, wherever possible I have provided a favorite deep link to a free public source that includes the relevant data, calculation, graphic, etc.

Some of the more important factors I look at are:

• Implied volatility, a great initial screening tool (higher is better) – free data at iVolatility.com; if you have an account at optionsXpress, they have excellent options screens available to all
  
  
• Beta (higher is better) is another good accelerant barometer, though not as good as IV – available many places, including Google Finance
  
  
• Number of analysts (lower is better) and degree of analyst consensus (lower is usually better) – Marketwatch.com has a page that not only summarizes the analyst estimates, but also provides a “coefficient variance” number that gives you a sense of the dispersion of opinion. In many cases, the earnings and/or revenue surprise is the fire starter.
  
  
• Short ratio: days to cover (higher is better) – a classic accelerant indicator, with free data available at ShortSqueeze.com

Some secondary factors to consider:

• Price to earnings ratio (negative or n/a is best, higher is better) – available many places, including Google Finance
  
  
• Earnings history data – there is a higher probability of a surprise if there is an erratic earnings history; there is also greater potential for a high magnitude surprise if there is a consistent pattern of beating (or missing) expectations – assuming the pattern can be broken. One fun source that has earnings dates baked in to charts and post-earnings performance data available is WhisperNumber.com (more complete data for larger companies.)
  
  
• Recent analyst ranking and/or price estimate changes (none is best) – these can work both ways, but most often they reduce the probability of a surprise. Again, Marketwatch.com is a good source.
  
  
• News flow – this is a highly subjective/qualitative assessment, but there are certain types of pre-earnings news that I believe can indicate in increased or decreased likelihood of an earnings surprise. Be particularly wary of binary events, such as the pending FDA approval for a drug and the like. The best place to find the relevant information is probably by looking at company news at Yahoo Finance. I am not ready to expand upon this one at this stage, except for…
  
  
• Recent company guidance (none is best) – as with recent changes in analyst opinion, these usually dampen the surprise potential. Again, try Yahoo Finance.
  
  
• Insider transactions – these are sometimes difficult to evaluate in the context of earnings, but if an apparent transactional pattern is confirmed or contradicted by earnings, there could be an accelerant. I favor Form4Oracle as a free public source of insider transaction data.
  
  
• Technical analysis – this is good for identifying the heightened possibility of breakouts, violation of important support and resistance levels, and other factors that may act as technical accelerants. The gallery view at StockCharts.com is always a good place to start.
  
  
• Put to call ratio (higher is better) – somewhat analogous to the short data is the individual stock open interest put to call ratio, data for which is available at SchaeffersResearch.com
  
  
• Recent options activity – another subjective and difficult to assess measure, but if significant changes in open interest favor either puts or calls, this may be a tell. Not much in the way of great public data, but you may get some valuable information from Yahoo Finance.
  
  
• Company size (lower is better) – this includes revenues and market capitalization. Available many places, including Google Finance.
  
  
• Recent IPO or lack of relevant operating history (less history is better) – In general, the shorter the track record, the bigger the chance for an earnings surprise. This means that the first quarterly report or two with new management, new products, a new acquisition, etc. increases uncertainty about the result – and the potential for a surprise.

As a footnote, if you are looking for a good source for who reports when that is sortable by time of day (BMO, AMC, etc.), I like TheStreet.com’s Earnings Release calendar, where you can click on the Date/Time column to sort accordingly. If you are not familiar with a lot of the tickers/companies, then I suggest that a first pass be limited to those companies with four letter tickers whose EPS estimate and/or previous year actual EPS is negative or close to zero.

Finally, I feel obliged to remind everyone that this is a method for finding the high potential post-earnings movers, *not* the winners. I continue to play with the weightings of the various factors and ultimately your weightings should reflect your research and beliefs about the market. If you keep track of the pre-earnings data and the outcomes, you should be able to develop and tweak your own model – or at least flag some potential high fliers.

CNBC Million Dollar Portfolio Challenge: #107,526

OK, so the graphic may be a little over the top, but at the beginning of the week I was #1047 and now it seems that all there is left for me to do is to have some more fun with the earnings spike potential algorithm.

With 1,598,913 contestants in this crazy contest, I can still stake a claim to the top 7%, but at the rate my portfolio is sinking, my ultimate goal may be to try to scramble back into the top 100,000.

The final damages from yesterday’s ride on OTEX turned out to total a 3.8% loss. For today, I listened to the algorithm for a change and hopped aboard LeapFrog Enterprises (LF). So far this is my best pick of the week…(wait for it)…down a mere 1.6% today.

With the always thin weekend, one has the opportunity to take a flyer on an M&A target (maybe Options Doggy can sniff one out), play for some Dendreon (DNDN) news, or go my standard earnings route. The earnings pickings are slim, but the algorithm generated the top four picks for Monday as follows:

1. Flamel Technologies (FLML)
   
   
2. Delta Petroleum (DPTR)
   
   
3. Cogent Communications Group (CCOI)
   
   
4. Kinross Gold (KGC)

For the record, I think Delta is a fascinating exploration and production play that is a good fit for someone who likes to swing for home runs. I have owned it in my real money portfolio for over a year and have traded around it a great deal too. For what it’s worth, I have also owned and traded Flamel since last October and still like the prospects for this biotech/drug delivery play. Once again, I’m going to follow the recommendation of the algorithm and go with FLML for Monday.

Next week is the final week for the CNBC contest and I intend to finish on a strong note.

CNBC Million Dollar Portfolio Challenge: #41,667

Some days you can console yourself with thoughts of, “Well…it could have been worse…” Yesterday that particular consolation was not a straw available for me to grasp at, as my ‘all in’ bet on i2 Technologies (ITWO) turned out to be on the stock that had the largest percentage decline across the entire universe of NYSE, Amex and Nasdaq stocks. The damage was considerable, dropping me some 40,000+ places from the top 0.1% to the top 3%.

The gory details about ITWO’s earnings boil down to a significant earnings miss; a drop in maintenance revenues (often an indication that customers are unhappy with the software); and news that the 57-year-old CEO is retiring – with comments that the Board of Directors have “started looking for a replacement.”

A couple of interesting things happened along the way to this implosion. The most obvious one is that my earnings spike potential algorithm has to be considered a resounding success, as its last two selections have notched impressive gains and another stock it rated highly, ITWO, showed impressive volatility yesterday, albeit in the wrong direction. Yes, this is a Pyrrhic victory, but it is one that may pay some real money dividends down the road.

The other aspect of this is the emotional one. I have never tried paper trading and do not recommend it for those looking to learn how to trade. ITWO turned out to be the perfect case study. It cost me over a half a million dollars yesterday and my reaction was mainly that of amusement over the magnitude of the loss. Apparently, the entertainment value of CNBC dollars far exceeds the portfolio value.

If these were real world dollars, I would probably have agonized over the gap down in ITWO yesterday, hoped for a bounce (yes, I know you should never let “hope” enter into your trading calculus), then cut my losses as the intra-day pattern of lower highs and lower lows failed to reverse. At least that’s what I like to I think I would have done. In practice, too many investors, particularly inexperienced ones, cling to these horror stories and search frantically for any stray piece of information that can justify their instinctive response to hold on – with this pattern repeated over hours, days, weeks and sometimes months.

Without any dollars at risk or emotions involved in holding ITWO, I dumped it unceremoniously at the end of the trading day (no intra-day trading is allowed in this contest) and looked for another potential high-flier. Today my CNBC dollars are riding on the Amkor Technology (AMKR) bus; while AMKR has been doing wonders for my Portfolio A1 portfolio, today it is up 1%, consistent with the gains in the broader market.

Hey, at least you don’t hear me proclaiming, “Mission Accomplished...”

CNBC Million Dollar Portfolio Challenge: #1227

It was just a matter of time before my string of good fortune came to an end, but for all practical purposes, it probably should not have been today. Still, at #1227 out of 1,441,536 contestants as of last night, I have managed to hold on to a top 0.1% rating for one more day.

Scrolling back a little, my current position is the result of a 2.8% loss in Wright Medical Group (WMGI) yesterday, putting an end to a nice run of six straight days of gains of 2% or more. As I described earlier, I had carelessly thought WMGI would report earnings before the market opened or during the day yesterday, but this turned out not to be the case. Had I held on to WMGI, I would be sitting on what is currently a 6% gain, but instead, I went back to my earnings spike potential algorithm. This handy tool had helped pick the six consecutive winners and had pointed to a couple of other big movers as well. Yesterday it spit out Atheros Communications (ATHR), currently up 7%, as the top choice. Between WMGI and ATHR, how could I go wrong? Well, I got cute and thought I might be able to get even more volatility out of i2 Technologies (ITWO), whose dangerous coiled spring cocktail includes a huge beta (over 10 on Yahoo), an equally impressive short position of 13.1 days to cover, and an implied call volatility of 60. Well, I got the volatility I wanted, but I missed out on the direction, as ITWO is trading down 28% this morning. It is only a small consolation to know that the algorithm seems to be working…

Depending upon how far I fall down the ranks today, I will make a determination whether I should roll the dice one final time with the likes of Dendreon (DNDN) in hopes of rocketing my way into the finals or just play for a respectable position, such as the top 1%. I know that this is only play money, but after having come this far, it seems silly to spend it all on one last lottery ticket.

CNBC Million Dollar Portfolio Challenge: Top 0.1%

OK, so I didn’t buy Amazon (AMZN) before their earnings report and missed an opportunity to log an ‘easy’ 27% gain yesterday. I still made up some ground, however, with a more than respectable 2.9% gain in VECO.

My portfolio is now up to $1.69 million, but with tenth place in the CNBC Million Dollar Portfolio Challenge at $2.93 million, the task ahead continues to be a formidable one. On the plus side, at #1260 out of 1,324,502 contestants, I can at least claim to have made it into the top 0.1%.

As this contest has progressed I have discovered the need for an earnings spike potential algorithm and have spent some time testing and refining such a beast. Yesterday, before the close, it kicked out three companies with a high potential to spike after they reported earnings after hours. The good news is that the algorithm (which I will be glad to talk about after this contest is over) produced three highly volatile plays for today: SWKS (up 21% a little after noon EDT); HLIT (down 15%); and ARBA (down 9%.) Of the three, I looked hardest at SWKS and ended up passing on this one, as well as the other two. The potential for volatility was certainly there, but I was concerned that it was more likely toe be in the wrong direction. Instead, I went with a slightly less volatile play that has been showing a lot more momentum in the run up to earnings: GSI Commerce (GSIC), whose retail e-commerce solutions helped deliver a quarter that was good enough to overcome two analyst downgrades that knocked the stock down early this morning. After opening down 5.3% this morning, the stock has rallied to where it is currently trading up 4% on the day.

And now for the horn tooting portion of this post. For those who are late to the CNBC party, in the past when I have tooted my own horn here I have used the opportunity to highlight one of my favorite horn players. First up were two jazz trumpeters: Clifford Brown; and Lee Morgan. Today I want to turn my attention to classical music and Dennis Brain, who may be the greatest classically trained horn player of the modern era. If you are not sure whether you are a fan of classical music, you owe it to yourself find a way to introduce your ears to Brain’s 1953 rendition of the Mozart horn concertos. If this turns out to be a transformational experience in your life, don’t say I didn’t warn you.