Gapping and Probabilities

While teaching an Accelerated Solutions Class to a group of Online Trading Academy graduates in Washington DC last week, I was asked an interesting question. A student had noticed two stocks that had large price gaps in reaction to earnings reports. They wanted to know if there were any strategies that could have been used to take advantage of the price movements after the morning gaps.

The two securities were Herbalife (HLF) and El Pollo Loco Holdings (LOCO). Both had large gaps upward due to positive earnings results. Even though they both moved up, they did not both offer the same opportunity.

The news doesn’t usually change things when it comes to Online Trading Academy’s core strategy. Supply and demand zones are still valid if they are strong. Earnings releases are no exception. If you do not know how to use the strategy and are still trying to trade stocks around their earnings release, you are essentially gambling with your trading capital.

Holding a trade into an earnings release is also a form of gambling. Many fortunes have been lost when a company released disappointing quarterly results. If you are an investor and do not want to exit, at least protect the position using options or futures contracts. If you are interested in trading the earnings releases, I would suggest looking at trading options. Do not try that without the proper training though.

So, we now understand that the higher probability trading opportunities lie after the earnings release. Let’s examine what often happens to price when those numbers do come out.

The first security that the student asked me about was El Pollo Loco Holdings, (LOCO). As expected, the stock gapped up on positive earnings. The problem was that when LOCO opened, it did so right into a weekly supply zone.

Most of the time when a stock opens into a strong supply, it will immediately sell off as professionals step in and sell to the novice buyers. But when the broad market is strong, like it was on the day after LOCO’s announcement, price will usually just move sideways. That is what we see happened in this case.

The other stock that the student asked about was Herbalife, (HLF). Due to positive earnings, price also gapped up. This time price opened short of the daily supply zone thus offering an opportunity to trade with the professionals.

You can see from the following chart that there was an abundance of buy orders at the open and price pushed higher. The sign that the novices were flooding the market with their buy orders can be seen by the large green candle that formed in the direction of the upward trend. As I have mentioned in previous articles, this is a sign of exhaustion in price as all of the buyers have now jumped in.

Almost immediately, price reversed and traded back not only to the beginning of the novice candle, but below it in order to shake out as many of the stop loss orders that were sitting there. The candle before the novice one acts as a demand zone where the professionals buy from the novices selling at a loss.

Price then runs up undeterred until it gets to the daily supply zone. This is where the professionals exit their trades. If you were aggressive, you could have also entered a shorting position to catch the afternoon move back down. There were no intraday supply zones available so you would have had to utilize other trading techniques in order to take advantage of that.

So there are definitely opportunities surrounding the earnings releases. I have only briefly discussed some here. To fully understand these opportunities, be sure to educate yourself. Trading without education is a sure way to lose. Trading with the proper education is a key to trading success.

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