Of Scavengers and Cleaner Fish

When most retail investors think of achieving gains in the stock market they think of the following scenario: buy a great stock at a good price, watch the company blow away earnings, and then get rewarded. This does happen. No question about it. However, there are other techniques that you will never hear about in commercial media that can offer relatively lower risk ways to supercharge your returns. That is the advantage of free press, of independent web pages, and of thinking outside of the box.

Here we will talk about what I like to call 'scavengers' and 'cleaner fish'. These two methods have an inverse relationship with each other and share core commonalities all at the same time... read on and you will understand.

First the commonalities... both of these methods involve holding shorts or longs on stocks... but not holding through earnings. This helps reduce risk. You are not dependent on what the company reports. The second element these two techniques share is that they are both trades... not buy and hold investments. Absolutely essential to these techniques are using pre-calculated buy in (or short) price points and calculated stops in case the trade goes the wrong way.

The difference? Each is usually done on the other side of earnings. Let's define each:

Cleaner Fish
Cleaner fish are those tiny fish that follow the big fish around, mostly sharks, and clean them. They remove parasites, among other items, from the big guys. This is their food. The shark gets cleaned, the cleaner fish gets fed and has protection, everyone wins.

In terms of the market, you can be a type of cleaner fish by riding with the big boys (or the masses... which together form a big boy) into earnings. If a stock traditionally rises before earnings because of the anticipation of a positive report you can look, usually a week or several weeks before earnings, for buy-in price that makes sense. The goal here, again, is not to hold the stock through earnings but to sell with a low-risk profit before earnings. To do this you define how high you think the price may go based on the chart, the company, etc... and also set a stop (either actual or a mental stop) in case the trade goes against you. Generally, you want the targeted upside gain to be at least 3 times the downside stop loss downside potential. So, if a stock is trading at 250... and you think it will likely go to 280 before earnings and based on support, etc... is not likely to go below 240 unless the trade goes wrong you would...
Buy at 250
Set a target of around 280 or higher
Set a stop loss a bit below 240.

The upside potential is 30 (280-250). The downside risk is 10 (250-240). 30/10 is 3:1. Of course... the stock might run higher than 280 before earnings... in which case the ratio would be even better. If the stock runs I recommend raising the stops to lock in gain... or sell outright, depending on the conditions. The key here is that you cannot violate the stop loss. If you decided that the stop was at 239, then if it hits 239, you need to sell (unless there is an extraordinary circumstance). This ensures that you cannot take a major loss relative to the potential gain. It's discipline that keeps cash in your pocket for the next opportunity. It uses the major tenets of trading...

1. Before getting in study the stock carefully and try to find the trade that puts the probability of success as much as possible in your favor
   
2. Cut losses short... let winners run (but watch them carefully... esp. in this market... and don't take on too much risk)

The actual earnings will not matter here. It is the pre-earnings interest that matters. You ride with the big fish... and with a lot of the traders that make a living doing trades like this (the other cleaner fish). You may not hit a homer here but you can get some nice gains with relatively low risk.

Readers may remember the play on ISRG that was pointed out earlier this summer. This was the cleaner fish mechanism in action. The result was a nice >10% gain as the stock did move from 250 up to 290 before earnings (see below). I recommended a sell before earnings since the strategy had paid off.

It turned out that ISRG had a phenomenal earnings report and went much higher. However, as I mentioned, to achieve those gains would have required taking on the risk of disappointing earnings and a major bear raid. Was that worth it compared to 10% already on the books? Usually, I recommend a specific plan be made (long term investment, trade, etc.) before entering a position and then stick to it. That's how I try to act at least... you of course must do what you think is best and helps you succeed.

Here is the chart...


ISRG moved from 250 (the recommended buy-in price... a long-term support area for the co.) to 290 before earnings. This was the 'cleaner fish' trade. The stock then had stellar earnings and shot up to about 330... and then slowly sold off (read the the rest of the post first... and then come back to this chart and see if you can identify the reverse (or short) scavenger trade that occurred here after earnings...)

For more on the ISRG play check out this post.....


Scavengers
Scavengers are on the other side of earnings. This trade involves staying away from a stock before and during earnings. After earnings, if the stock gets crushed, the scavenger trade may be a sweet deal. A lot of times stocks that barely miss, or don't miss at all but for some reason do not impress, just get clobbered. Part of this is due to the fact that investors holding the long side might be leveraged and may be forced to sell due to margin calls. Sometimes a stock faces a bear raid in which the stock gets heavily shorted. Other times the sentiment in the market at the moment the stock reports is overly pessimistic. At any rate, the key is to try to see if the stock has been unfairly beaten up and is likely to bounce back a bit, or a lot, after the rubble clears. Short covering alone may provide a bounce. However, ideally, there are a number of converging factors that make the probability of an upwards move high. As with the cleaner fish trade, it is important to pick an entry point, based on technicals and sometimes fundamentals, that allows for a high probability trade with a up/down target of 3:1 or better. Again, stops, etc. are usually used to define risk reward and prevent any substantial financial losses.

This recent chart of AAPL, which shows earnings on it, provides an excellent example of a potentially successful scavenger trade . On July 22nd AAPL stock was taken to the woodshed because they gave mediocre guidance (which they always do)... The scavengers were all over this. When the stock reached 150 it bounced up sharply. to close at 162 on that day. By July 23rd it had gone as high 168... for a potential gain of almost 15% (ok... we're using round numbers...) in just two days. It's very tough to get the exact top and bottom but a gain of well over ten percent was very possible here. Please note that the stock went down for a while after that. This is why stops are so important. This type of move is a trade... not an investment... thus stop losses should be employed. Once the trade becomes positive it should always stay positive, or at least remain break even for you. For example, a trader might have raised the stop to 159 after the first day and then 165 on July 23rd... locking in a move to at least 165......... for a nice trade.

RIMM doubled earnings, then the stock just got clobbered. This also presented a nice scavenger trade. However, the stock continued down after the initial drop. This illustrates an important point- good scavenger trades are not necessarily initiated right after earnings. In the case of RIMM the stock had moved up 40% in a relatively short period of time before earnings. Also, the margin compression, reported on the conference call, spoke of the threat of the iPod to the Blackberry. In this case it is prudent to be a bit more careful. For many situations like this the best thing is to do nothing initially... but to watch the charts carefully. At some point, for a company as strong as RIM, the stock is likely to be sold off too much, hit RSI levels of 30 and bounce up, get some positive news, etc. Once the rebound begins there can be a very nice move up. When RIMM reached just above 100 (102 to 105 area) there was the potential for a nice trade with a stop loss somewhere below 100. It is also true that technology stocks tend to do well from mid summer forward as part of the Christmas (Xmas) season cycle... and the fact is that RIMM did double earnings and said on the conference call that they expected the second half of the year to show strong gains. As I have said before, the goal of trading is to put as much probability in favor as possible while taking on the minimal amount of risk. Even if you had mistakenly bought RIMM right after the initial stock drop, by using stops, you could have limited your losses and been ready for when it did turn around.

The chart shows that a purchase, once the bounce upward was established around 102 on July 15th, would have yielded some very nice results indeed! Note, that the reasons behind rebounds such as this, besides the cheaper valuation and money flow into tech in this case, are that many of the traders/investors that like RIMM and sold it after the earnings release are looking for an opportunity to get back in... it's the flow of funds... Additionally, there are the professional traders that make a living off of such moves, other scavengers... and so when the momentum shifts there is a nice probability of a move up. As an aside, not only does tech often go up starting in mid summer due to Xmas, stocks in general tend to move up going into the months of an election.

Also... I heard McCain will be giving away free Blackberry's and Obama... as the CHANGE candidate... will be offering free iPods... to anyone who will vote for em...

As Dr. Evil from Austin Powers said... 'No.Not really. I can't back that up'...
(Any opportunity to mention the early Austin Powers movies is worth taking... also I had to mention something about the elections... what the heck does change mean? Is he going to change his boxers if/when he becomes President? Often?)

Don't get me wrong... it's smart, because America is more about emotional reactions and consensus belief than about thinking these days... not the readers of the 'Rose' though... or you wouldn't be here...

This line remains such a beaut... I still cringe when I hear it...
"The problem here is that there will always be some uncertainty about how quickly Saddam can acquire nuclear weapons. But we don't want the smoking gun to be a mushroom cloud."
CondoSleezza Rice

How about issues instead of ridiculous sound bites... I guess I am asking too much.

The point is that many factors converged to make RIMM a potentially appealing buy around 105 or even a bit higher as the momentum re-entered the stock...

There are many many similar examples. In this market many of the scavengers are playing the other side. Wait for a stock to rise before earnings... watch it beat earnings... and then short it when the oscillators turn back down. That is what happened with FSLR... and many others (have I ever mentioned the fertilizer stocks)... Regarding the potash stocks I gotta say it takes guts to short a company trading at a Forward PE of 10, tripling earnings, and guiding higher... but hey... they were either very lucky or there is more than meets the eye here... for another post maybe...


Please note the island type reversal sell-off after earnings at the end of July after the large run-up going into earnings. This transpired despite very solid earnings...

For now tuck these two techniques away somewhere. At first you may want to watch on the sidelines for these moves. Then as you learn more you may be willing, and able, to bring in the cha ching...

Now take a look at the ISRG chart above.......
-------------------------------------------------
One last thing... take a look at the charts of MOS and POT... time to be a scavenger? These charts look to be basing. For MOS if it can break and hold the 200 MA above 108 or if it falls back to the 100 area or slightly below... I might use a stop just below 95... this could be a very nice opportunity here. For POT, I would like to see it hold above 180 before adding more or fall back to 170 with a stop around 168 or 169... just a heads up. I'm not making predictions here... I am saying that the probability of moves up in these names is starting to get much higher... MOS and POT are trading 34% and 27%, respectively, from their highs... and the technicals are starting to look better...
--------------------------------
This video demonstrates why being the big fish... even when the feeding seems good... can be risky... it's also just shows the awesome and terrifying power of the wild











"The Yellow Rose Street Beat" is for informational purposes only. It does not give investment advice.