Last week confirmed that I still like earnings season, which as behavioral adaptations go, is a good idea, as it never seems to end. Better to learn to like it than to fight it.
Based upon comments heard over the past few weeks, approximately 25% of the year represent critical earnings weeks. You simply can’t escape the news, nor more importantly the impact.
Or the opportunity.
Of the earnings related trades examined last week, I made trades in two: Facebook (FB) and Seagate Technolgy (STX). The former trade being before earnings and the latter after, both involving the sale of out of the money puts. Both of those trades met my criteria, as in hindsight, did Chipotle Mexican Grill (CMG), but there’s always next quarter.
While hearing stellar numbers from Netflix (NFLX) and Facebook are nice, they are not likely to lead an economy and its capital markets forward, although they can lead your personal assets forward, as long as you’re willing to accept the risks that may be heightened during a weakening market.
With “implied volatility” continuing to serve as my guide there are a number of companies that are expected to make large earnings related moves this week and they have certainly done so in the past.
Again, while I seek a 1% ROI on an investment that is hoped to last only for the week, the individual investor can always adjust the risk and the reward. My preference continues to be to locate a strike price that is outside the range suggested by the implied volatility, yet still offers a 1% or greater ROI.
Typically, the stocks that will satisfy that demand already trade with a high degree of volatility and see enhanced volatility as earnings and guidance are issued.
The coming week is another busy one and presents more companies that may fit the above criteria. Among the companies that I am considering this coming week are Anadarko (APC), British Petroleum (BP), Green Mountain Coffee Roasters (GMCR), International Paper (IP), Michael Kors (KORS), LinkedIn (LNKD), Twitter (TWTR), Yelp (YELP) and YUM Brands (YUM).
As with all earnings related trades I don’t focus on fundamental issues. It is entirely an analysis of whether the options market has provided an opportunity to take advantage of the perceived risk. A quick glance at those names indicates a wide range of inherent volatility and relative fortunes during the most recent market downturn.
Since my preference is to sell puts when there is already an indication of price weakness this past week has seen many such positions trading lower in advance of earnings. While they may certainly go lower on disappointing news or along with broad market currents, the antecedent decline in share price may serve to limit earnings related declines as previous resistance points may be encountered and serve as brakes to downward movement. Additionally, the increasing volatility accompanying the market’s recent weakness is enhancing premiums, particularly if sentiment is further eroding on a particular stock.
Alternatively, rather than following the need for greed, one may decide to lower the strike price at which puts are sold in order to get additional protection wile still aiming for the ROI objective.
As always when considering these trades, especially through the sale of put options, the investor must be prepared to own the shares if assigned or to manage the options contract until some other resolution is achieved.
Strategies to achieve an exit include rolling the option contract forward and ideally to a lower strike or accepting assignment and then selling calls until assignment of shares.
The table above may be used as a guide for determining which of selected companies may meet the risk–reward parameters that an individual sets, understanding that adjustments may need to be made as prices and, therefore, strike prices and premiums may change.
The decision as to whether to make the trade before or after earnings is one that I make based on perceived market risk. During a period of uncertainty, such as we are presently navigating, I’m more inclined to look at the opportunities after earnings are announced, particularly for those positions that do see their shares declining sharply.
While it may be difficult to find the courage to enter into new positions during what may be the early stages of a market correction, the sale of puts is a mechanism to still be part of the action, while offering some additional downside protection if using out of the money puts, while also providing some income.
That’s not an altogether bad combination, but it may require some antacids along the way.