Want to Buy NOW or Other Stocks at a Discount after an Earnings Miss? Wait Three Days.
Earnings season has already had a handful of blowups as Netflix (NFLX) fell $35 on earnings, and PayPal (PYPL) and ServiceNow (NOW) both lost more than 4% following disappointing results. While I really like the potential of these stocks to bounce back, particularly ServiceNow stock (more on that one later), my experience tells me that I should would wait at least three days before buying these stocks. I call it The Three-Day Rule.
I began my career on the floor of the Chicago Board of Options Exchange in 1999 straight out of college. For a year, I stood next to two options trading legends, soaking up all of their wisdom as their clerk. That year, the market ripped higher as virtually every dot-com stock exploded higher day after day. I learned a great deal during that bull run.
Once considered a niche segment of the investing world, options trading has now gone mainstream. With little knowledge on the best strategies, you can use options to work the odds in your favor and make trades that have up to an 80% probability of success. Find out how in this free report, How Options Work—and How to Hedge Portfolios with Options.
Once considered a niche segment of the investing world, options trading has now gone mainstream.
With little knowledge on the best strategies, you can use options to work the odds in your favor and make trades that have up to an 80% probability of success. Find out how in this free report, How Options Work—and How to Hedge Portfolios with Options.Read Your Free Report Here.
Here is a picture of a younger me (with more hair) in my trading pit on the CBOE.
Soon after I became a trader myself, and the Nasdaq fell apart. The dot-com bubble burst, and valuations were reset for virtually the entire market. I learned even more during those bearish years than during the bull market years!
The old trading rule that was hammered into my brain by my two trading legend mentors was this:
If a stock takes a big fall, whether it’s on earnings or some other news event, you MUST wait at least three trading days before even thinking about putting on a bullish position.
The rationale behind The Three-Day Rule is that if a large hedge fund or institution owns millions of shares of a stock, it won’t be able to sell out of its entire position in a day or two without causing the stock to fall.
My Netflix (NFLX) Example
Instead, the institution will parcel out its sales over a couple of days, so they don’t depress the stock and can sell at better prices.
For example, let’s take a look at Netflix (NLFX), which fell from 362 to 325 in on July 18 on a disappointing earnings release. That was a staggering fall! The next day, the downgrades came pouring in from the brokerage houses (thanks for the downgrades after the fall, people!).
Based on the three-day trading rule, I wouldn’t have considered adding a bullish position on Friday, July 19, Monday, July 22 or Tuesday, July 23. But on Wednesday, July 24, according to the rule, I could begin to think about adding a bullish position.
Here were NFLX’s closing prices on the day of its earnings report and the following days:
July 17 – 362
July 18 – 325
July 19 – 315
July 22 – 310
July 23 – 307
July 24 – 318
July 25 – 326
July 26 – 336
As you can see, there remained selling pressure on NFLX in the days after the big drop. Then, slowly but surely, the stock stabilized, and buyers began to take over.
ServiceNow Stock and the Three-Day Rule
I did not buy the dip in NFLX after the three days that the rule mandated because other stocks offered much better opportunities than NFLX. But I may try to buy ServiceNow (NOW) Calls in the coming days if my Unusual Options Screening tool tells me that big traders are stepping in and buying ServiceNow stock Options.
And if NOW Option Order Flow turns bullish, with the stock trading today at 280, I might look to buy the November 290 Calls for $18.
What makes buying these calls so attractive is that my downside is limited by my premium outlay on the trade: $1,800 per call purchased. This is a significant discount to paying $28,000 for 100 shares of the stock. And if ServiceNow stock stabilizes, and runs back to its old highs and beyond, my upside is unlimited!
However, if this earnings miss was a sign of bad things to come, and NOW is a short and the stock drops, the most I can lose on the trade is $1,800 per call purchased.
As earnings season continues next week with reports from Match.com (MTCH), Planet Fitness (PLNT) and Carvana (CVNA), there will inevitably be some big drops in stocks you have interest in buying. However, before buying the dip that first day, remember what all experienced floor traders refer to as The Three-Day Rule.
Jacob Mintz is a professional options trader and Chief Analyst of Cabot Options Trader. He uses calls, puts and covered calls to guide investors to quick profits while always controlling risk. Beginners and experts alike can gain from following Jacob’s advice.Learn More
*This post has been updated from an original version, published in 2016.