An Earnings Season Warning You Shouldn’t Miss

James DiGeorgia

It’s easy to feel smart when stocks are in a bull market and seemingly each one you choose heads higher.

But the mistakes and outright blow-ups teach us the most about investing.

Unfortunately, those mistakes can blow you right out of the markets if you bet too big and can’t recover from those losses.

But even if you’ve spent a lifetime in the markets, that doesn’t mean you stop making mistakes.

It just means you get more practice at managing them when they happen!

Even after trading and investing for 34 years, I still make mistakes.

Recently I made one that was avoidable, in a stock right before the company announced Q4 earnings.

Now that its Q1 earnings report is just around the corner, I need to make sure I make the right decision this time around.

One Way I Measure the Market Action

My partner Geoff Garbacz and I use several trading tools when it comes to picking stocks. Following trader sentiment is a big part of our process.

We watch the trading action very closely to see whether the bulls or bears go long or short stocks and indexes.

There are many ways you can monitor the sentiment of an actively traded security. For example, you can:

  • Look right at the charts and see whether a stock is trending up or down.
  • Monitor stocks’ short ratios or their options chains to see the buying and selling activity.
  • Follow the Volatility Index (VIX) and other indicators that reflect how traders and investors are reacting to the markets.

There are also more-advanced tools out there that Geoff and I use. Whichever ones you rely on, my caution is this …

If you use sentiment indicators — or any other type of trading tools — they work best when you listen to them consistently.

In fact, the only time I have really taken a beating in the last nine years was when I wasn’t laser-focused on sentiment indicators.

However, if you pick-and-choose when to listen to your indicators, this can result in lost profits even on the small scale.

Many of you know I like the potential upside for Vipshop Holdings (VIPS), the Chinese Internet discount commerce giant.

The Chinese, like many other cultures, place a value on being able to pay full price. Companies that sell designer clothing, cosmetics, electronics and more have benefited.

The culture in mainland China has been that buying at discount was gauche or was somehow demeaning. But thanks to the Internet, that’s changing.

Millions of Chinese are discovering discount shopping. Suddenly VIPS has become a multibillion-dollar enterprise.

I entered my position roughly 90 days ago at about $22 a share. My target price for the VIPS was $29 a share.

In early February, five of the six sentiment indicators I followed were positive on VIPS.

But then, something changed.

On Feb. 10, these critical indicators suddenly and quickly moved to neutral and then to a clear sell signal. VIPS then pulled back to $21.

By Feb. 24, only one of my favorite sentiment indicators remained positive!

I decided not to worry because VIPS had a history of pulling back just before earnings. And its newest earnings report was just around the corner.

In the past, it had even flashed a weak sell signal … only to beat estimates and rally!

But also in the past, VIPS has gotten a great tailwind from the success and growth of other Chinese Internet plays that were reporting.

So, exiting on the weak sell signal just didn’t make sense to me.

Bottom line, I wanted to be long VIPS.

Unfortunately, in late February Chinese Internet companies weren’t announcing good news — they started struggling.

Baidu Inc. (BIDU) plunged 10% after missing Q4 earnings expectations.

Most investors would have cut their position loose after the terrible Baidu report.

But not me.

I was too stubborn about VIPS’ ultimate-long term potential to cash out and sit on the sidelines.

While I didn’t exit the trade, I did decide to hedge it with “put insurance.” That is, I bought put options to hedge my long shares against a pullback.

Because I owned 1,500 shares of VIPS, I bought 15 contracts of the VIPS February $20.50 Puts.

This insurance cost me roughly $60 per contract to hedge my long shares in a 1-to-1 ratio. (One option contract represents 100 shares of the stock.)

That gave me the right to sell my shares at $20.50 by February options expiration, if I chose to exercise that right.

If the stock went up, I could exit the puts, or let them expire and remain with my long shares.

Click this link to read more about how to hedge against an earnings surprise.

By buying these puts, I essentially added 60 cents to the cost of my position. My cost investment in the 1,500 shares now averaged about $22.60.

Worthless Options, But a Valuable Strategy

The put insurance I bought turned out not to be necessary. The puts expired without value, but the protection they provided in case the stock dropped after earnings helped me to sleep better at night.

Because I paid 60 cents a share for those puts, and paid $22 for the stock, I now have a $22.60-per-share cost basis.

VIPS ended the trading day Friday at $30. I think we could see it head to $32 before its next earnings release on May 14.

So, even with the cost of the puts, that’s a 32.7% gain before broker fee and commissions.

Long term, I could see VIPS climbing to its Alpha Scorecard upper limit price target of over $100. The Scorecard looks closely at a company’s free cash flow and determines whether a stock is undervalued.

VIPS look increasingly likely of hitting the lower limit price target of $33.37 a share as we approach the May 14 earnings announcement.

The stock recently hit a new 52-week intraday high at $30.17.

Now the key question is, should I buy put insurance again?

Given that, five of the six sentiment indicators I follow are telling me to remain bullish, I’m opting not to buy puts this time around.

Can things change? Yes.

But this time, I’m staying focused on what my favorite sentiment indicators are telling me, and paying less attention to how other, similar stocks are trading.

That’s why I look at other indicators like free cash flow (via the Alpha Scorecard). I also look closely at how a stock tends to trade around earnings and other major events.

There are no hard-and-fast rules about when to buy, sell or protect your stocks. That’s because each has its own unique factors that will affect where it heads next.

But when you stick to a process and use it for every name in your portfolio, you should see more-consistent results.

Always Watching Your Chickens,

James DiGeorgia

With contributions from Geoff Garbacz, Phil Erlanger and Dawn Pennington