Trading Contract Awards
The United States federal government spends over $400 billion per year on federal contracts for goods and services. A large portion of that spending is determined through a competitive bidding process. Businesses of all sizes are free to bid on an available government contract. In addition to federal government contracts, state and local governments also procure goods and services through a similar, competitive bidding process. Companies also contract with other companies to provide goods or services they need outside of their area of expertise. So, there are many opportunities for businesses to earn revenue by contracting with all levels of government as well as other businesses.
How do contract awards impact stock prices?
Since the bidding process can be highly competitive, receiving a contract is somewhat of a prize for a company. Regardless of whether the source is another company or a federal or local government agency, being awarded a new contract is an important financial event. So, publicly traded companies usually issue an announcement or press release when they get a new contract award. Contract awards are positive news events that typically push the stock price higher.
The current stock price represents the market valuation of the firm’s expected future cash flows. When a company gets a new contract award, this is a new source of revenue that the market had not priced into its current valuation. The market must adjust its valuation of the company, and as a result, the stock price should rise.
While new contract awards result in additional revenue for companies, the amount that a particular contract can move a stock price can vary. Although all new contracts represent unexpected additional revenue for the firm, the stock price may not move much if the contract is a relatively small percent of annual revenue. So, the bigger the award from a contract, the more the company’s stock price will increase because of the news. Smaller contracts may not move the stock price significantly for very large firms (high market capitalization), but they can be a huge source of additional revenue for smaller companies. So, a smaller dollar contract can still increase cause a large increase in the stock price of a smaller company.
How to Trade
Before deciding to place a trade on a contract award announcement, it is important to do some additional research. Investors need to consider how large the contract award is in comparison to the market cap of the firm. If the contract is a small percent of annual revenue, the stock price may not increase much at all. So, it may not be worthwhile to make a trade. If the dollar amount of the contract award is relatively high compared to annual revenues, there is a greater chance that the stock price will increase significantly and provide a reasonable return on the trade. Investors should also check to see if there is any other news in the overall market or within the company itself that could potentially push the stock down and overshadow the news of the contract award.
If an investor has ruled out the potential impact of bad market news and believes the market reaction to the contract award will be significant, there are three moves to watch following the news event. Each of these moves represents a potential trading opportunity. The first move is the initial pop in the stock price that occurs very quickly as the market reacts to the unexpected news. These reactions, however, often cause the stock price to overshoot its initial target valuation. When this happens, a quick decline, or pull back, in the stock price follows the initial pop. Investors who miss the opportunity to trade on each of these quick market events, however, can still trade on the trend. Throughout the trading day, and often for several days following the event, the stock price continues to increase as the new information filters into the market and investors re-evaluate their expectations about the firm’s future earning.
Get more detailed information by reading The Three Moves for Event Based Trading.