Reversal During Earnings-Announcements

Despite the fact that earnings announcements are anticipated events in most cases, multiple academic papers find the evidence that they still affect stock prices and therefore create a potentially profitable trading opportunities. For instance, one of the recent works shows that the short-term reversal is much stronger around the days of earnings announcement than in other, randomly chosen periods. More precisely, the LOW-HIGH (buying past losers and selling past winners) strategy yielded an average 3-day return (the window of t-1, t, and t+1, where t is the day of earnings announcement) of 1.45% during the 1996-2011 sample period, whereas the average return during random pseudo-announcement periods was only 0.22% (therefore more than a six-fold difference). The phenomenon, as suggested by the authors, is related to market makers‘ decisions regarding liquidity provision (see fundamental reason). The strategy further described is carried out on the subsample of big stocks due to better liquidity.

Fundamental reason

In general, reversal in price of an asset occurs due to investors' overreaction to asset-related news and the subsequent price correction. In this case, the most probable reason for the phenomenon, according to the authors, is the market makers‘ aversion to inventory risks that tend to increase dramatically in the pre-announcement period. Consequently, the market makers demand higher compensation for providing liquidity due to higher risk and therefore raise prices, which are expected to reverse after the earnings announcement.

Markets traded
equities
Confidence in anomaly's validity
Strong
Notes to Confidence in anomaly's validity
Period of rebalancing
Daily
Notes to Period of rebalancing
Number of traded instruments
1000
Notes to Number of traded instruments
more or less, it depends on investor's need for diversification
Complexity evaluation
Complex strategy
Notes to Complexity evaluation
Financial instruments
stocks
Backtest period from source paper
1996-2011
Indicative performance
63.52%
Notes to Indicative performance
per annum, annualized (arithmetically, assuming 10 rebalances per quarter) average 3-day return of high-size stocks (Q5 SIZE quintile), data from table 5
Estimated volatility
12.29%
Notes to Estimated volatility
estimated from t-statistic, data from table 5
Maximum drawdown
not stated
Notes to Maximum drawdown
Sharpe Ratio
4.84

Keywords:

earnings announcement, equity long short, reversal, stock picking, trading earnings

Simple trading strategy

The investment universe consists of stocks listed at NYSE, AMEX, and NASDAQ, whose daily price data are available at CRSP database. Earnings-announcement dates are collected from Compustat. Firstly, the investor sorts stocks into quintiles based on firm size. Then he further sorts the stocks in the top quintile (the biggest) into quintiles based on their average returns in the 3-day window between t-4 and t-2, where t is the day of earnings announcement. The investor goes long on the bottom quintile (past losers) and short on the top quintile (past winners) and holds the stocks during the 3-day window between t-1, t, and t+1. Stocks in the portfolios are weighted equally.

Hedge for stocks during bear markets

Not known - Source and related research papers don't offer insight into correlation structure of proposed trading strategy to equity market risk, therefore we do not know if this strategy can be used as a hedge/diversification during time of market crisis. Strategy is built as a long-short, but it can be split into 2 parts. Long leg of strategy is surely strongly correlated to equity market however short-only leg can be maybe used as a hedge during bad times. Rigorous backtest is however needed to determine return/risk characteristics and correlation.

Source Paper

So, Wang: News-Driven Return Reversals: Liquidity Provision Ahead of Earnings Announcements
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2275982
Abstract:
This study documents a six-fold increase in short-term return reversals during earnings announcements relative to non-announcement periods. Following prior research, we use reversals as a proxy for expected returns market makers demand for providing liquidity. Our findings highlight significant time-series variation in the magnitude of short-term return reversals and suggest that market makers demand higher expected returns prior to earnings announcements because of increased inventory risks that stem from holding net positions through the release of anticipated earnings news. Collectively, our findings suggest that uncertainty regarding anticipated information events elicits predictable increases in expected returns to liquidity provision and that these increases significantly affect the dynamics and information content of market prices.

Hypothetical future performance

Other Papers

Jansen, Nikiforov: Fear and Greed: a Returns-Based Trading Strategy around Earnings Announcements
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.