A Reversal-Based Trading Strategy around Earnings Announcements Wednesday, 2 November, 2016

A related paper has been added to:

#307 - Reversal During Earnings-Announcements

Authors: Jansen, Nikiforov

Title: Fear and Greed: a Returns-Based Trading Strategy around Earnings Announcements

Link: http://www.wsj.com/public/resources/documents/FearandGreedJPM0922.pdf

Abstract:

This study documents that earnings announcements serve as a reality check on short-term, fear and greed driven price development: stocks with extreme abnormal returns in the week before an earnings announcement experience strong price reversal around the announcement. A trading strategy that exploits this reversal is profitable in 40 of the last 42 years and earns abnormal returns in excess of 1.3% over a two day-window.

Notable quotations from the academic research paper:

"In this study, we develop a trading strategy around earnings announcements that seeks to profit from predictable reversals of fear and greed driven price development in individual stocks. We argue that earnings announcements are logical events around which to center such a trading strategy, because they convey fundamental information about asset prices and thus have the potential to “break” irrational price development. Moreover, because of heightened information asymmetry in the period just before an earnings announcement, price development is probably particularly susceptible to excessive fear or greed. That is, if uninformed investors observe sharp price changes just before an earnings announcement, they may attribute these to the informed trading of insiders; start to excessively trade in the same direction themselves; and thus cause an overreaction. We therefore predict—in the spirit of Warren Buffett’s advice—that stocks that experience sharp price changes just before an earnings announcement will experience price reversal at the time of the announcement itself. We test this prediction with a trading strategy that on the earnings announcement date takes (1) a long position in stocks that experienced extreme negative abnormal returns in the week prior, and (2) a short position in stocks that experienced extreme positive abnormal returns in the week prior.

We find that, over the two day window of the earnings announcement date and the day following, both positions are highly profitable. On average, the long position earns abnormal returns of 1.49%, and the short position earns 1.20%. We furthermore show that these return reversals are about 60% larger than around non-earnings announcement dates, and thus are significantly more pronounced than short-term return reversals documented in the prior literature. We also show that our strategy (1) is profitable in 40 of the 42 years in our sample; (2) is similarly profitable in “bear” and “bull” markets; (3) and is significantly profitable for both large firms and high volume stocks. Since the year 2000—using a conservative transactions costs estimate of 70 basis points for a round trip trade—we find that our strategy generates abnormal returns of 0.76% after transaction costs, or 95% on an annualized basis. We conclude, therefore, that prices are subject to sentiment-driven price development in the period of elevated information asymmetry just before earnings announcements, and that the announcements themselves serve as a reality check on that price development."


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