Have you ever seen a stock drop in price despite an earnings report that met or even beat expectations? Or one that rallies furiously after merely meeting expectations? What gives?

The answer is often contained in the sentiment environments surrounding the stocks prior to the event.

Why Do Some Stocks Drop After Good Earnings?

When a stock falls after a company announces earnings results that meet or beat expectations, chances are sentiment was excessively bullish heading into the event, which creates high expectations of a blowout report.

High expectations can be a dangerous situation if the company disappoints the market by merely meeting expectations. They can also create what is called a "crowded trade," which leaves little money to flow into the stock after the earnings release, no matter how positive the report.

Why Do Some Stocks Rally After Only Meeting Expectations?

When a stock soars after a company announces results that merely met expectations, it's likely that sentiment was very bearish heading into the announcement. Low expectations (lower whisper number, increasing put volume and short interest, lower analyst ratings) can lead to large post-earnings moves higher if earnings simply meet expectations.

In other words, the expectation bar is set so low that meeting earnings projections is considered a positive for the stock.

Often the result is that cash that was withheld from the stock based on pre-earnings pessimism pours into the market, pushing up demand and the share price.

The Key to Picking the Best Earnings Trades

Knowing how to properly position your portfolio based on a proper assessment of the sentiment surrounding a stock before earnings can pay off handsomely after earnings come in. And the best way to leverage these sharp moves is through options, which can yield big results on large, quick moves in the right direction.

The key to picking the right stock for an earnings play is to find situations in which pessimism is evident during an uptrend (for a long position) or optimism is present during a downtrend (for a short play).

4 Stocks: 1 Hot, 3 Not

Now we're going to look at three stocks that are awash in optimism and should be handled with great caution.