Bad News, High Vol and a Chance to Trade
Sometimes, markets react in a predictable manner. One of those times is when bad news is released. When a company announces almost any news that disappoints traders, the immediate reaction is to sell. The selling is the trigger for a predictable chain of events.
Although markets are complex, one simple rule governs price action. When sellers are more motivated than buyers, prices fall. When buyers are acting with a greater sense of urgency than sellers, prices rise. Bad news motivates sellers and tends to push prices down.
Once prices start falling, another rule governing price action kicks in. Because of a mathematical relationship known as the put call parity formula, volatility rises when prices fall and this pushes up the volatility factor in option pricing models.
In other words, selling tends to lead to increased volatility and this volatility tends to lead to increased options prices. The result is an opportunity for traders who follow the news.
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A Slow Moving News Story Sets Up a Trade
Although traders tend to believe price action almost immediately incorporates the news, there are times when it takes weeks for the market to see the full impact of an event. This was the case for Hasbro, Inc. (Nasdaq: HAS).
The toy maker announced earnings on Monday and the results for the most recent quarter were better than expected. The company reported a profit of $265.6 million, up 3% from a year. Earnings per share (EPS) were $2.09.
Revenue came in at $1.79 billion. According to management there was strong demand for games such as Monopoly and Magic: The Gathering and My Little Pony toys.
Both EPS and revenue were better than expected. Analysts on average had expected sales of $1.78 billion and EPS of $1.94.
But, management raised concerns about the current quarter. This was especially troublesome to traders since the fourth quarter of the year is probably the most important for retailers, a fact that is especially true for a toy company which depends on strong holiday sales.
Management noted that the surprise bankruptcy filing last month by Toys’R’Us had a significant impact on the company. This seems like it should not have been a surprise to analysts since Hasbro reported that it typically sells about 9% of its total inventory through Toys’R’Us stores.
While analysts seem like they should have been concerned about the possibility of debt recovery and decreased sales, they were instead raising estimates. In the past six months, analysts increased their estimated EPS for the current quarter while just three cut their earnings outlook.
In a call with analysts after the earnings were released, management explained there was cause for concerns related to the Toys’R’Us bankruptcy. Hasbro has extended credit to the retailer for inventory and estimates exposure of about $60 million in unsecured claims for payment.
Management provided an estimate for the fourth quarter of an increase of 4% to 7% in sales above last year’s fourth quarter total of $1.63 billion. At the upper end, this places revenue at about $1.74 billion. Wall Street analysts had been expecting stronger growth to drive revenue above $1.8 billion.
Management did their best to allay concerns. “As a result of the Toys’R’Us bankruptcy filing in the U.S. and Canada, there was a negative impact on our quarterly revenues and operating profit,” Hasbro’s Chief Executive Brian Goldner said in a statement.
“We continue to work closely with Toys’R’Us as we head into the holiday period,” he noted while suggesting this is a problem that can addressed relatively quickly calling it a “short-term disruption” for the company.
He was also optimistic about the future. “It wouldn’t have been an issue had it happened earlier this year,” Goldner said. “The current situation will not be an issue for us in 2018. We have increasingly found great homes for our great products.”
Goldner also sought to assure traders the company was acting with caution, noting, “We paused shipment for a short period as we gain clarity. Our finance and Toys ‘R’ Us commercial teams worked on an agreement we signed a few days ago… We just need to determine what Toys ‘R’ Us can receive in the next few months.”
The Market Reacts Quickly
The chart below shows the impact of the news was immediate with HAS gapping down at the open and continuing to move lower as traders analyzed the news.
This news adds to the stock’s woes. As the chart shows, HAS has been in a downtrend and its recent selloff led to increased volatility. The higher volatility seen after the news of the disappointing earnings increased options premiums even more. This is normal when a steep selloff occurs.
Now, put options are trading at high prices. Those high price suggest an alternative strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility. In this case, with a bearish outlook, a call option should be sold.
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 is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in HAS
For HAS, we could sell a November 3 $91 call for about $0.60 and buy a November 3 $92 call for about $0.40. This trade generates a credit of $20, which is the difference in the amount of premium for the call that is sold and the call that is bought multiplied by 100 since each contract covers 100 shares.
The credit received when the trade is opened, $20 in this case, is the maximum potential profit on the trade.
The maximum risk on the trade is $80. The risk is found by subtracting the difference in the strike prices ($100 or $1.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($20).
This trade offers a return of about 25% for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if HAS is below $90 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 $80 for this trade in HAS.
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