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A Loss Could Lead to a Break Out Opportunity

A Loss Could Lead to a Break Out Opportunity

As companies report earnings, the stock often reacts. In some cases, the reaction can offer important technical signals to traders.

This is possibly the case with a company that recently reported earnings. The Associated Press recently reported that New Relic Inc. (NYSE: NEWR) reported a loss of $16.8 million in its fiscal fourth quarter.

The company said it had a loss of 30 cents per share. Earnings, adjusted for stock option expense and non-recurring costs, came to 13 cents per share.

The stock sold off on the news. The chart below shows the selling pressure comes with the stock at an important support level and could be the beginning of a larger move in the stock price.

NEWR daily chart

New Relic, Inc., a software-as-a-service company, provides various digital products worldwide. Its cloud-based platform and suite of products include New Relic Platform, which enable organizations to collect, store, and analyze data. The company offers New Relic Application Performance Monitoring that provides visibility into the performance and usage of server-based applications, including data pertaining to response time, transaction throughput, error rates, top transactions, and user satisfaction; New Relic Mobile.

The results beat Wall Street expectations. The average estimate of 11 analysts surveyed by Zacks Investment Research was for earnings of 6 cents per share.

The cloud-based software analytics company posted revenue of $132.1 million in the period, which also beat Street forecasts. Seven analysts surveyed by Zacks expected $128.2 million.

For the year, the company reported that its loss narrowed to $40.9 million, or 72 cents per share. Revenue was reported as $479.2 million.

For the current quarter ending in July, New Relic expects its per-share earnings to range from 7 cents to 8 cents.

The company said it expects revenue in the range of $138 million to $140 million for the fiscal first quarter.

New Relic expects full-year earnings in the range of 54 cents to 62 cents per share, with revenue ranging from $600 million to $607 million.

The weakness in the stock comes near the lower edge of an extended trading range. For the past year, as the weekly chart below shows, the shares of NEWR have been in a relatively narrow trading range. The failure to move higher could signal a down trend is likely in the stock.

NEWR weekly chart

A Trading Strategy To Benefit From Weakness

A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.

In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.

Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.

One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.

Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.

The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.

bear call spread

Source: The Options Industry Council

While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.

You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.

Every day, we scan the markets looking for trades that carry 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.

A Bear Call Spread in NEWR

For NEWR, we could sell a June 21 $95 call for about $3.05 and buy a June 21 $100 call for about $1.15. This trade generates a credit of $1.90, which is the difference in the amount of premium for the call that is sold and the call.

Remember that each contract covers 100 shares, opening this position results in immediate income of $190. The credit received when the trade is opened, $190 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $310. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($190).

This trade offers a potential return of about 61% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if NEWR is below $95 when the options expire, a likely event given the stock’s trend.

Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $310 for this trade in NEWR.