A Big Jump on News Sets Up a Possible Triple Digit Gain
With options, it can be possible to trade after news is released and still realize large trading gains. That’s the case for a stock that recently jumped more than 7% after announcing earnings.
Starting with the news, The Street reported,
“Shares of Illinois Tool Works (NYSE: ITW) jumped [recently] after a strong third-quarter-earnings report from the toolmaker.
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The Glenview, Ill., industrial group’s net income rose to $2.04 a share from $1.90 a share in the year-earlier period. Revenue slipped 3.7% to $3.48 billion.”
Illinois Tool Works Inc. is a manufacturer of industrial products and equipment. The company operates through seven segments.
The Automotive OEM segment produces components and fasteners for automotive-related applications. The Food Equipment segment offers commercial food equipment.
The Test & Measurement and Electronics segment produces test and measurement, and electronic manufacturing and maintenance, repair and operations (MRO) solutions.
The Welding segment produces welding equipment, consumables and accessories for industrial and commercial applications.
The Polymers & Fluids segment produces adhesives, sealants, lubrication and cutting fluids, and fluids and polymers for auto aftermarket maintenance and appearance.
The Construction Products segment supplies engineered fastening systems and solutions.
The Specialty Products segment produces beverage packaging equipment and consumables, product coding and marking equipment and consumables, and appliance components and fasteners.
The Street continued,
“A survey of analysts by FactSet was expecting earnings of $1.94 a share on revenue of $3.54 billion.
Operating margin widened 0.4 percentage point to 25%; free cash flow rose 12% to $830 million; and after-tax return on invested capital added 1.2 percentage points to ITW delivered the results even as “the demand environment continued to moderate across a broad cross section of our portfolio,” Chief Executive E. Scott Santi said in a statement.
The company affirmed its full-year 2019 GAAP EPS guidance of $7.55 to $7.85 a share, compared with $7.60 in 2018. FactSet’s survey was looking for $7.58.
llinois Tool Works stock at last check traded at $170.94, up 6.8%. Through Thursday’s close, ITW stock had been up 26% in 2019.”
The longer-term chart shows the price is now at new highs and could move sharply based on the price pattern.
A Trade for Short Term Bulls
As with the ownership of any stock, buying ITW could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for ITW
Every day, we scan the markets looking for trades with low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
For ITW, the December 20 options allow a trader to gain exposure to the stock.
A December 20 $175 call option can be bought for about $3.27 and the December 20 $180 call could be sold for about $1.82. This trade would cost $1.45 to open, or $145 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $145.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in ITW the maximum gain is $3.55 ($180- $175= $5; $5 – $1.45 = $3.55). This represents $355 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $145 to open this trade.
That is a potential gain of about 144% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.