- Leapday Quantitative Research Team
Sticking to the fundamentals: Improving entry and exit timing with REACTION signals
In this report we examine how REACTION signals can be used by fundamental and quantamental investors to improve the timing of entering and exiting trades around earnings events. After earnings announcements, stocks often jump up or down in response to the events and investors may find opportunities to enter or exit trades. We demonstrate that the 10 day REACTION signal released before the close on the first day of trading after an earnings event and after the initial market jump can be used to delay taking profits in already established positions, delay entering new positions to achieve better entry prices, or confirm initiating trades immediately to lock in the best prices.
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Leapday’s REACTION signals predict short-term moves (2-15 trading days) after earnings announcements. These signals are released at 3 entry points after the event day, which is defined as the first day the market is open subsequent to a company’s earnings announcement. These 3 entry points are: (1) 60 minutes after the open on the event day (t0 open + 60min); (2) just before the market close on the event day (t0 close); (3) before the open on the next trading day after an event day (t1 open).
We have written numerous reports in which we use these signals to construct event-driven market neutral portfolios. These reports use signals on over 3,000 stocks, are focused on short-term 3 day trades, and construct portfolios designed for systematic investors.
We are, however, frequently asked by fundamental and quantamental investors how these signals can be beneficial to their investment processes. These investors take large concentrated positions in fewer names, their focus is often very specific (sector, industry, theme), and the duration of their trades is longer. Below we identify two use cases in which fundamental investors can use the REACTION signals to improve entering and exiting trades around earnings events.
Delay taking profits? - An investor has a winning trade in their portfolio. At the next earnings release the company reports results that corroborate the investor’s position and increase the investor’s profits. The investor wants to reduce the position and take some profits. Should they start to close the position out today, tomorrow, or in a few weeks?
Delay entering a position? - An investor has a company on their watchlist. The company releases earnings and the stock moves to a new extreme price level. The investor likes this company at the new price but should they start to establish a position today or wait a few days to get even better prices?
We investigate the two use cases above by focusing on the REACTION t0 close 10 day signal. We choose the 10 day signal in this analysis because it provides a long enough time for investors to incorporate the new information released by the company into their valuation models. We proceed by presenting a few examples for each use case above, providing performance for the signal across all stocks, and discussing the findings.
Delay Taking Profits?
Consider a case where a fundamental investor has a profitable position established and the company reports earnings. The latest release pushes the stock to a new, more profitable price level at which the investor believes it is time to start offloading some of the risk of the position. The reaction signal can be used to help an investor determine when to offload that position. Below we take a deeper look at a few specific examples.
The first example is Bed Bath and Beyond (BBBY). After the steep COVID sell-off in February and March of 2020, some investors may have decided to go long the stock. This would have been a profitable trade over the next few months. On September 30, 2020 the company reported Q2 earnings after the close and the stock popped an additional 25.1% the next day. Should investors have taken that profit or held the trade for longer? The Leapday REACTION t0 close 10d signal had a score of 90 indicating a strong buy. Investors who didn’t immediately exit this trade and held for another 10 days saw the stock increase 33.1% (27.2% when beta-adjusted) from the close on the event date to the close 10 days later as shown in the chart below.
Another similar example is Palantir Technologies (PLTR). The company went public on September 30, 2020 at $10 a share. An investor who purchased the stock at or near the IPO saw a run up in price going into earnings on November 13, 2020. The stock then jumped another 8.4% on the earnings date. Should investors who bought at or near the IPO but had bearish views on the company have taken profits after the earnings bump? The Leapday t0 close 10 day signal was 85 indicating a strong buy. Ten days later, this stock was up 71.6% (70.9% when beta-adjusted) from the close on the event date as shown on the chart below.
Next we examine a winning short trade in which an investor would like to know if they should delay their exit for additional profits. We take a look at Tripadvisor (TRIP). The stock reported earnings on February 16, 2017. In the months leading up to this event, the stock had dropped considerably and then fell 11.0% on the earnings date, falling to new lows. An investor who was short this stock going into earnings might have been tempted to exit the trade and take their profits. However, the REACTION t0 close 10 day signal came in at -85 indicating a strong sell over the next 10 days. As the chart below shows, TRIP stock fell 11.0% (14.3% when beta-adjusted) from the close on the event date to the close 10 days later. An investor who used the REACTION signal to delay their exit would have added considerably to their profits.
In the examples above we showed how the REACTION signals can be used to delay taking profits in established positions to lead to considerably larger gains in some cases. Next, we take a look at a second use case in which an investor wants to initiate a new position in a company but is waiting for a reasonable price to enter the trade.
Delay Entering A Position?
We next look at the scenario in which an investor has a company on their buy watchlist and the company’s stock is at near-term lows. The company releases earnings and the stock drops further. An investor wants to know if they should wait any longer to buy at a lower price. Below we look at an example.
Pioneer Natural Resources (PXD) reported earnings on August 2, 2017. The stock had been down going into earnings and was at near term lows. After earnings, the stock dropped 10.8%. However, the 10 day REACTION score was a -88 indicating a strong sell over the next 10 days. As shown on the chart below, by waiting 10 more days an investor would have been able to buy the stock 9.6% cheaper (also 9.6% when beta-adjusted) relative to the close on the event date and caught the stock just before it began to move up.
Next we take a look at the opposite scenario in which a stock is on a short watchlist, the price is at near term highs, but the REACTION 10 day signal is a buy indicating that an investor should wait to initiate their short. We look at Asana (ASAN). The company reported earnings on September 2, 2021. Going into earnings the company’s stock had risen dramatically in the previous 6 months and popped 15.4% on the earnings date to new highs. An investor who was bearish on this stock may have been tempted to short this stock. However, the 10 day REACTION signal was a strong buy at 83 suggesting the investor should wait before initiating this short trade. This action would have been prudent as ASAN rose 32.6% (33.7% when beta-adjusted) in those 10 days after the event date before beginning to drop sharply in subsequent months as shown in the chart below.
Next, we take a look at situations in which the REACTION signal can be used as confirmation for initiating a trade on a watchlist. In this scenario, a company is on a portfolio manager’s buy watchlist, the stock is at a near-term low, and the investor is looking for a catalyst to initiate a long position.
An example of this is FuboTV (FUBO). The company reported earnings on May 12, 2021. Going into earnings the stock was at near-term lows. Upon releasing earnings, the stock jumped 9.7% in the first day of trading and the REACTION t0 close 10 day signal was strong buy with a score of 89. An investor who used this signal as confirmation to enter this trade would have made 22.4% (15.1% when beta-adjusted) from the close on the event date to the close 10 days later and even more as they held the position over the next few months as shown in the chart below.
In this section we showed how REACTION signals can be used to delay entering new positions or confirm entering new positions in order to achieve better entry prices. The examples presented in the last two sections are instances when the REACTION signals performed very well. However, the signal is not a crystal ball and in order to present a balanced story we present summary metrics that show how the signals did on average when used to time entry and exit points.
In this section we expand the analysis of the use cases above across all stocks in our coverage between 2016 and 2021. We examine two scenarios: (1) The stock moves up between the t-1 close and t0 close and the REACTION t0 close 10 day signal is a buy; (2) The stock moves down between the t-1 close and t0 close and the REACTION t0 close 10 day signal is a sell. These two scenarios cover both use cases above in which an investor has an existing position and wants to optimally time the exit after an earnings announcement pushes the stock to even more profitable levels as well as when an investor has a company on a watchlist and wants to optimally time the entry after an earnings announcement pushes the stock to even more extreme levels. Unlike the examples mentioned above, this analysis also includes cases when a company is not at a recent high or low before the event.
For both of these scenarios, we report the average return in the 10 days after the t0 close 10 day signal. We focus the analysis on strong signals that fall in the top decile of REACTION scores. It should be noted that average returns we present in this analysis (as well as the stock moves between the t-1 close and t0 close) are beta-adjusted to prevent any market direction bias that might be present in the sample. We additionally breakdown the analysis based on the size of the move between the t-1 close and t0 close. We look at a binary move up or down and we also study moves that are in the 50th percentile of moves or larger.
We start by showing performance for the first scenario in the chart below in which the stock moves up between the t-1 close and t0 close and the REACTION signal is a buy.
The chart above indicates when a stock moves up between the t-1 close and the t0 close and the REACTION t0 close 10 day signal is a strong buy, the stock continues to move up an average of 1.26% over the next 10 days. We define a “Big Jump Up” as a positive move in the top 50 percentile of moves or larger between the t-1 close and t0 close. For these cases the stock continues to move up an average of 1.69% over the next 10 days. For fundamental investors taking large positions and looking to time exits on winning long positions or investors looking to time entry into short trades on a watchlist, these are meaningful contributions to P&L.
We repeat the above analysis for only the 500 most liquid stocks to examine the signal’s usefulness for the largest stocks in the universe. The chart below shows these results. When the stock moves up between the t-1 close and the t0 close and the REACTION t0 close 10 day signal is a strong buy, these stocks move up 1.72% on average over the 10 days. When you filter for the top 50 percentile of moves or larger between the t-1 close and t0 close (a “Big Jump Up”), these stocks continue to move even higher with an average incremental return of 3.38% over the next 10 days.
Next, the chart below takes a look at the opposite scenario in which the stock moves down between the t-1 close and t0 close and the REACTION signal is a strong sell.
The chart above indicates when a stock moves down between the t-1 close and the t0 close and the REACTION t0 close 10 day signal is a strong sell, the stock continues to move down an average of -1.11% over the next 10 days. We define a “Big Jump Down” for events that exceed the top 50th percentile of negative moves between the t-1 close and t0 close. For these events the stock continues to move down an average of -1.35% over the next 10 days. For fundamental investors taking large positions and looking to time exits on winning short positions or investors looking to time entry into long trades on a watchlist, these are meaningful contributions to P&L.
The chart below shows the same analysis but using only the most liquid 500 stocks. The results indicate that when the stock moves down between the t-1 close and the t0 close and the REACTION t0 close 10 day signal is a strong sell, the liquid 500 stocks move down -0.42% on average over the 10 days. When you filter for a “Big Jump Down” in the top 50 percentile of moves or larger between the t-1 close and t0 close, the liquid 500 stocks continue to move down an average of -0.74% over the next 10 days.
Above we showed that by pairing the REACTION signal with the overnight jump up or down a fundamental investor can improve the timing for entering and exiting new or existing positions. Furthermore, the strength of this signal and the subsequent expected incremental return can be amplified by focusing on more extreme jumps up and down.
In this report we showed how the REACTION signals can be used to help the timing associated with entering and exiting positions for fundamental investors. In some cases the REACTION signal indicates a trade should be taken immediately to lock in the best prices while in other cases we demonstrate how the signal indicates a trade should be entered or exited more patiently after an earnings event to get the best prices.
When a stock has a jump up on the event date and the REACTION signal is a strong buy we see the stock move 1.26% higher on average over the next ten days. When the events are further constrained for only the biggest 50% of jumps up the return increases to 1.69%. Similarly, when a stock jumps down on the event date and the REACTION signal is a strong sell we see an average return of -1.11% over the next ten days. For events where there is a big jump down the subsequent 10 day return is further amplified with an average of -1.35%. All of these results also hold for the 500 most liquid stocks in the universe.
This material is solely for informational purposes and is not an offer or solicitation for the purchase or sale of any security, nor is it to be construed as legal or tax advice. References to securities and strategies are for illustrative purposes only and do not constitute buy or sell recommendations. The information in this report should not be used as the basis for any investment decisions. We make no representation or warranty as to the accuracy or completeness of the information contained in this report, including third-party data sources. The views expressed are as of the publication date and subject to change at any time. Hypothetical performance has many significant limitations and no representation is being made that such performance is achievable in the future. Past performance is no guarantee of future performance.