An Unexpected Earnings Trade
Traders tend to look for volatility during earnings season. That makes sense because companies are updating investors and analysts on their financial performance. The news requires analysts to update their models and might force investors to reevaluate their positions. Stock prices should react to this.
However, sometimes, the price moves are not very large. That could be because the company is large and growing slowly but it is also possibly due to the fact that the company’s management teams does a good job communicating with analysts.
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If management explains their expectations to analysts, the analysts will be able to develop more accurate earnings forecasts. That means the companies should be able to deliver earnings fairly close to expectations and that would result in small price moves for the stock.
One company that communicates well with analysts is Walmart Inc. (NYSE: WMT). Walmart is the ubiquitous retailer with big box stores all over the country. Its size makes it relatively difficult to grow quickly and WMT has reported average sales growth of just 1.3% a year over the past five years.
Predictability Can Be Tradable
While traders often pursue high growth in stocks, the truth is that slow growth could also be rewarding. Companies that are growing slowly have a degree of predictability and data shows that appears to apply to Walmart.
On average, the company reports earnings that are 1.3% above analysts’ expectations. The average one week price move after the earnings announcement is a small loss of 0.3%.
As a point of comparison, another large retailer, Foot Locker Inc (NYSE: FL), has missed analysts’ consensus earnings expectations by an average of 5.9% and the stock falls an average of 6.5% in the week after earnings are announced.
Walmart’s relative predictability can result in little volatility in the stock price. The chart below shows that the stock has been trading in a relatively narrow range for months.
The longer term chart, using weekly data, shows that this type of trading in the stock is not all that unusual. WMT frequently trades in a relatively narrow range.
Knowing this, there is a profitable trading opportunity for traders willing to take positions expecting a lack of volatility in the stock.
A Strategy to Benefit From a Calm Market Environment
For Walmart, there is a relatively high likelihood of a relatively narrow trading range. One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in Walmart
For Walmart, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, May 18.
The difference in the exercise prices of the calls or puts is equal to $1.00. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $100 less the premium received when the trade was opened.
Selling the options will generate $1.74 in income ($0.99 from the call and $0.75 from the put). Buying the options will cost $1.25 ($0.75 for the call and $0.50 for the put). This means opening the trade will result in a credit of $0.49, or $49 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($1.00) minus the premium received ($0.49). This is equal to $0.51, or $51 since each contract covers 100 shares. Many brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $51 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $0.49 or $49 per contract.
The potential reward on the trade ($49) is about 96% of the amount risked, a best return on investment for a trade that will be open for about one week. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
This trade could also be closed out early to reduce the potential risks of the trade. It could still deliver its maximum gain even if the position is closed before the expiration date of the options.
The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.