An Earnings Beat Drives a Gain, and Sets Up a Potential 77% Gain In May
Earnings reports often create volatility and volatility is an important factor in options pricing. That means we will often find opportunities in options during earnings earnings season. A recent earnings announcement from Capital One Financial Corporation (NYSE: COF) set up the trade.
PR Newswire reported that Capital One reported net income for the first quarter of 2019 of $1.4 billion, or $2.86 per diluted common share, compared with net income of $1.3 billion, or $2.48 per diluted common share in the fourth quarter of 2018, and with net income of $1.3 billion, or $2.62 per diluted common share in the first quarter of 2018.
TheStreet.com noted that this was above analysts’ expectations of $2.68 in the period. Adjusted revenue of $7.08 billion was also above Wall Street’s $7.01 billion expectations.
The stock moved sharply higher on the news.
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“In the first quarter, revenue, pre-provision earnings, and earnings per share all increased compared to the first quarter of 2018,” said Richard D. Fairbank, founder, chairman and CEO. “As our digital transformation accelerates, we are well positioned to succeed in a rapidly changing marketplace and create long-term shareholder value.”
Looking ahead, Capital One will become the exclusive issuer of Walmart’s private label and co-branded credit card program in the U.S. beginning August 1, 2019. The company’s earnings last quarter reflected some charges involved in setting up that account.
When that partnership was announced, the companies noted, “Walmart and Capital One share a common goal of transforming the way they serve customers through digitally-led innovations.
This new relationship combines Walmart’s size, scale and leadership in omni-channel retailing with Capital One’s long-standing position as a technology leader within the retail financial services market.
Leveraging their respective technology platforms and individual capabilities, Walmart and Capital One intend to offer highly innovative, digitally-enabled credit card products that deliver great value to customers and an exceptional cardholder experience.”
The results of that deal could drive stronger results later in the year and for the next several years. The strong quarter, and expected strength in the next few quarters, could push COF out of its extended trading range towards new highs.
A Trade for Short Term Bulls
As with the ownership of any stock, buying COF 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 COF
Every day, we scan the markets looking for trades that COF 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 COF, the June 21 options allow a trader to gain exposure to the stock.
A June 21 $95 call option can be bought for about $2.15 and the June 21 $97.50 call could be sold for about $1.25. This trade would cost $0.90 to open, or $90 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 $90
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 COF the maximum gain is $1.60 ($97.50 – $5 = $2.50; $2.50 – $0.90 = $1.60). This represents $160 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $90 to open this trade.
That is a potential gain of about 77% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.