Post-Earnings Announcement Drift (PEAD) Trading Strategy

Post-Earnings Announcement Drift (PEAD) is a well-documented market anomaly where stock prices continue to drift in the direction of an earnings surprise for some time following the announcement.

This provides traders with an opportunity to exploit the delayed response of the market to new earnings information.

Like all strategies, it isn’t foolproof, and is just a general tendency.

Key Takeaways – Post-Earnings Announcement Drift (PEAD) Trading Strategy

• Timing
  • Capitalize on the predictable stock price movement within a few days after earnings announcements.
  • Delays in information integration sometimes occurs for various reasons, such as discretionary trading making capital allocation decisions with a delay relative to systematic strategies.
• Stock Selection Matters
  • Focus on companies with significant earnings surprises.
  • They tend to exhibit stronger and more sustained post-earnings drifts.
• Risk Management
  • Implement strict stop-loss and take-profit levels to reduce risks associated with this type of strategy.

Understanding PEAD

PEAD occurs because the market doesn’t fully incorporate the implications of earnings announcements immediately.

This inefficiency can be attributed to various factors, such as:

• trader/investor inattention to certain details of the release
• slow dissemination of information, or
• differing interpretations of the earnings data
• behavioral biases like overconfidence and anchoring
• limited analyst coverage for certain stocks
• complexity of the earnings report
• delays in institutional trading decisions (e.g., discretionary strategies take time to price in because it requires human oversight)

Key Elements of the PEAD Strategy

Earnings Surprise

An earnings surprise occurs when a company’s reported earnings differ significantly from analysts’ expectations.

For example, you often hear of “consensus” expectations for a stock.

Then you hear of “actual” when earnings is released.

Positive surprises generally lead to upward drifts.

Negative surprises lead to downward drifts.

Market Reaction

The initial market reaction to earnings announcements often doesn’t fully reflect the new information.

Traders can often capitalize on the continued price movement in the direction of the surprise.

Steps to Implement the PEAD Strategy

Identify Earnings Announcements

Track the earnings calendar to identify upcoming announcements.

Focus on companies with a history of significant earnings surprises.

Naturally, these tend to be businesses with more volatile earnings, such as fast-growing companies or those with more cyclical earnings patterns.

Analyze Earnings Results

Compare the reported earnings to the consensus estimates.

Identify whether the announcement constitutes a positive or negative surprise.

Assess Market Reaction

Observe the initial market reaction post-announcement.

Look for signs that the market hasn’t fully priced in the earnings information.

You can build a DCF model and plug in the numbers to see how it flows through the model.

For instance, if the earnings surprise boosted the stock by 2% post-earnings, but your model suggests it should really be a +5% move, that could be a candidate for further consideration.

Execute Trades

Enter a long position if the earnings surprise is positive and the initial reaction is modest.

Conversely, enter a short position for negative surprises with insufficient initial downside movement.

Monitor and Adjust

Regularly monitor the position for price drift.

Adjust the strategy based on new information or significant price movements that suggest the drift has played out.

Risk Management

Position Sizing

Carefully manage the size of each trade to avoid excessive exposure to any single earnings announcement.

Stop-Loss Orders

Use stop-loss orders to limit potential losses if the market moves against the expected drift.

Diversification

Diversify the trades across different sectors and companies to spread risk and reduce the impact of any single earnings announcement.

Advantages of PEAD Strategy

Exploiting Market Inefficiencies

The PEAD strategy takes advantage of the market’s slow reaction to new earnings information, so it could provide an edge for informed traders.

Empirical Support

Numerous academic studies and empirical evidence support the existence and profitability of the PEAD phenomenon.

But again, it’s not foolproof.

Challenges & Considerations

Information Overload

Keeping track of numerous earnings announcements and analyzing each one can be time-consuming and complex.

Most analysts or traders who trade individual stocks can only keep track of a handful.

Market Volatility

Earnings announcements can cause significant volatility, requiring traders to remain vigilant and responsive to rapid price changes.

Transaction Costs

Frequent trading around earnings announcements can incur substantial transaction costs.

Let’s look at some trades using the post-earnings announcement drift (PEAD) trading strategy.

Trade 1: Positive Earnings Surprise

Company = XYZ Corp
Reported Earnings = $1.50 per share
Consensus Estimate = $1.20 per share
Initial Market Reaction = +2% on the announcement day

Step 1: Preparation

Research

Identify XYZ as a candidate for PEAD by tracking its earnings announcement calendar and analyzing past earnings surprise patterns.

Capital Allocation

Decide on the capital allocation for this trade.

Let’s assume a trading account with $50,000.

Allocate 10% of the capital, which is $5,000, for this trade.

Step 2: Earnings Announcement Analysis

Earnings Surprise Calculation

Calculate the earnings surprise as follows:

Earnings Surprise = (Reported Earnings – Consensus Estimate) / Consensus Estimate * 100

= (1.50 – 1.20) / 1.20 * 100 = 25%

Initial Reaction

The stock price increased by 2% on the announcement day, indicating a positive but possibly underreacted market response, depending on how it might feed through a valuation model (e.g., DCF).

Step 3: Enter the Trade

Trade Date = the day after the announcement
Stock Price = Assume the stock closed at $50 on the earnings release date
Number of Shares to Buy = Calculate the number of shares to buy with the allocated capital:

Number of Shares = Capital Allocated / Stock Price

= 5000 / 50 = 100 shares

Order Type

Place a market order to buy 100 shares of XYZ Corporation at the opening price on the day after the earnings release.

Step 4: Monitor the Trade

Price Movement

Monitor the stock’s price movement over the next few days to weeks.

Target Price

Set a target price based on historical drift magnitude.

For example, aim for a 10% increase from the initial purchase price (if supported by valuation and historical data), which would be:

Target Price = $50 * 1.10 = $55 per share

Stop-Loss

Set a stop-loss order to limit downside risk, e.g., 5% below the purchase price:

Stop-Loss Price = $50 * 0.95 = $47.50 per share

Step 5: Exit the Trade

Exit Criteria

Exit the trade when the stock reaches the target price, hits the stop-loss, or shows signs of the drift reversing.

Profit Calculation

If the target price is reached:

Profit = (Target Price – Purchase Price) * Number of Shares

= ($55 – $50) * 100 = $500

Trade 2: Negative Earnings Surprise

Company = ABC Inc.
Reported Earnings = $0.80 per share
Consensus Estimate = $1.00 per share
Initial Market Reaction = -3% on the announcement day

Step 1: Preparation

Research

Identify ABC Inc. as a candidate for PEAD by tracking its earnings announcement calendar and analyzing past earnings surprise patterns.

Capital Allocation

Allocate 10% of the capital, which is $5,000, for this trade.

Step 2: Earnings Announcement Analysis

Earnings Surprise Calculation

Calculate the earnings surprise as follows:

Earnings Surprise = (Reported Earnings – Consensus Estimate) / Consensus Estimate * 100

= (0.80 – 1.00) / 1.00 * 100 = -20%

Initial Reaction

The stock price decreased by 3% on the announcement day, indicating a negative market response.

Is it too much or too little?

Step 3: Enter the Trade

Trade Date = day after the announcement
Stock Price = Assume the stock closed at $30 on the earnings date
Number of Shares to Short = Calculate the number of shares to short with the allocated capital:

Number of Shares = Capital Allocated / Stock Price
= 5000 / $30 ≈ 167 shares

Order Type

Place a market order to short 167 shares of ABC Inc. at the opening price on the day after the announcement.

Step 4: Monitor the Trade

Price Movement

Check the stock’s price movement over the next few days to weeks.

Target Price

Set a target price based on historical drift magnitude.

For instance, look for a 10% decrease from the initial short price, which would be:

Target Price = $30 * 0.90 = $27 per share

Stop-Loss

Set a stop-loss order to limit downside risk, e.g., 5% above the short price:

Stop-Loss Price = $30 * 1.05 = $31.50/share

Step 5: Exit the Trade

Exit Criteria

Exit the trade when the stock reaches the target price, hits the stop-loss, or shows signs of the drift reversing or stalling.

Profit Calculation

If the target price is reached:

Profit = (Short Price – Target Price) * Number of Shares

= (30 – 27) * 167 = $501