Another Trade Set Up By An Earnings Miss
Earnings season is a time of volatility. And, there are good reasons for volatility.
Stock prices reflect what analysts and investors know about a company. Earnings announcements provide new knowledge about a company and that creates a need to revise price models and expectations. In this way, volatility is required.
Now, volatility can push up a stock price up or down. Each type of move deserves its own analysis.
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Earnings Misses Are Important to Note
Every quarter, most companies beat analysts’ expectations. In a typical quarter, about two thirds of companies will report results that are better than expected. One reason is because management teams provide guidance to analysts.
Analysts will use that guidance to craft estimates and then management will, hopefully, beat the estimates to show that they are doing better than analysts realized. In some ways, this can be thought of as a game, but it’s the way that the relationship between companies and analysts has worked for years.
Now, since the goal is to beat expectations and the fact is that about two thirds of companies do that, missing expectations can carry important information for traders. Companies that miss could be ideal short term trade candidates as a recent miss demonstrates.
Zacks recently reported that BWX Technologies (NYSE: BWXT) came out with quarterly earnings of $0.61 per share, missing the Zacks Consensus Estimate of $0.62 per share. This compares to earnings of $0.46 per share a year ago. As is typical for earnings reports, figures are adjusted for nonrecurring items.
This quarterly report represents an earnings surprise of -1.61%. A quarter ago, it was expected that this supplier of nuclear fuel and components to the U.S. government would post earnings of $0.60 per share when it actually produced earnings of $0.58, delivering a surprise of -3.33%.
Over the last four quarters, the company has surpassed consensus EPS estimates just once. That could explain the stock’s steep selloff. Traders are concerned that management is unable to meet expectations when so many other companies are able to.
BWX also missed on revenue, posting sales of $425.51 million for the quarter ended September 2018, missing the Zacks Consensus Estimate by 8.32%. This compares to year-ago revenues of $419.36 million. The company has topped consensus revenue estimates just once over the last four quarters.
The stock has now been in a downtrend since late January and the news indicates this trend could continue.
It is unlikely the stock can rebound without significant news, given the tendency to disappoint analysts, the good news is unlikely to be an analyst upgrade.
That means an earnings announcement could be the next potential catalyst for an up move in the stock. That won’t come for three months which leaves ample for trades to benefit from weakness in the stock.
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.
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.
A Bear Call Spread in BWXT
For BWXT, we could sell a November 16 $45 call for about $2.20 and buy a November 16 $50 call for about $0.30. 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 about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if BWXT is below $45 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 BWXT.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.