A Miss, and a Rally
The market’s reaction to earnings can seem unpredictable at times. Typically, a strong earnings report is followed by gains in the stock price. Or, a report that misses analysts’ expectations is followed by weakness in the stock.
But, sometimes, an unexpected reaction occurs. These reactions could be important to traders focused on the short term. An unexpected reaction is likely to result in follow through. In other words, if a company misses expectations and the stock rallies, traders should not look for a sell off later.
This provides opportunities for trades as we will explain after digging into a recent example.
Ulta Misses on Bottom Line
Headline writers found an important point in the earnings release from Ulta Beauty, Inc. (Nasdaq: ULTA). The company released its most recent quarterly financial results and the bottom line, or reported earnings per share (EPS), came in below expectations.
Ulta Beauty, Inc. is a beauty retailer primarily in the United States and calls itself “the premier beauty destination for cosmetics, fragrance, skin, hair care products and salon services.”
Ulta reported adjusted earnings of $2.75 per share and revenues of $1.94 billion. The reported EPS was slightly below analyst’s expectations which had been for EPS of $2.77. Revenue was in line with expectations.
Ulta’s revenues jumped 15.7% from $1.58 billion in the year-ago period. For the full year the company posted sales of $5.88 billion. Looking ahead to its upcoming first quarter, Ulta expects to post revenues between $1.51 billion and $1.52 billion, in line with analysts’ estimates of $1.52 billion.
“The Ulta Beauty team delivered excellent results in 2017, achieving 11 percent comparable sales growth and 25 percent adjusted earnings growth,” CEO Mary Dillon said in a statement.
“Looking ahead to 2018, we are deploying a portion of the tax reform benefits to invest in our people and accelerate investments to drive growth and innovation.”
A Long Term Market Leader
Ulta has long been a favorite of momentum traders as the long term chart of the stock below shows. This chart uses monthly data.
The stock moved almost straight up as the bull market began in 2009 before peaking after a gain of more than 5,400% in May 2017.
The stock’s more recent action appears to be consistent with the formation of a bottom rather than a continuation of the decline that has lasted almost a year.
The stock failed to reach a new low in the February sell off. Technical analysts believe this is a sign of demand for the stock where traders come into the market as buyers when prices fall to levels near recent lows.
The reaction to the earnings report, a strong rally, is consistent with that interpretation of the chart pattern. More gains are likely in the stock given the current price action.
A Trade for Short Term Bulls
As with the ownership of any stock, buying ULTA 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.
A Specific Trade for ULTA
For ULTA, the April 20 options allow a trader to gain exposure to the stock.
An April 20 $225 call option can be bought for about $6.00 and the April 20 $230 call could be sold for about $4.50. This trade would cost $1.50 to open, or $150 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 $150.
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 ULTA the maximum gain is $3.50 ($230 – $225 = $5.00; $5.00 – $1.50 = $3.50). This represents $350 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $150 to open this trade.
That is a potential gain of more than 130% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.