Before Earnings, Come Some Pre-Earnings Announcements
Companies turn to the stock market at times to raise cash to fund their operations. This is a primary reason many companies complete an initial public offering (IPO). But, the offering comes with a set of responsibilities and a requirement to disclose material information is one of the primary responsibilities.
This responsibility means management must tell investors whenever they learn of something that is material to the business. The most obvious material information is earnings and companies disclose full financial statements every three months.
In preparing those quarterly statements, sometimes management learns something that is important to investors. Under the law, they have an obligation to disclose that information to investors immediately. The result is often a preannouncement of earnings.
Bad News Often Comes Early
One example of how a company can be forced to disclose preliminary results is GoPro (Nasdaq: GPRO) which was forced to release preliminary fourth quarter 2017 results that show the company might be in a struggle for its survival.
On Monday, management announced that the company plans to lay off at least 250 employees to reduce its headcount to less than 1,000 employees. The headcount reduction is possible because the company now also plans to exit the drone market.
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In a step intended to reduce investor concerns, management also announced that the CEO will be paid just $1 in 2018. The market looked at that as a token solution to a serious problem and the stock sold off. This continues a long decline in the price of the company’s shares.
Traders knew the company was under pressure and some layoffs were expected. Last week TechCrunch reported that several hundred employees were relieved of duties though officially kept on the books until the middle of February.
The web site reported the bulk of the layoffs happened in the engineering department of the Karma drone. GoPro confirmed that division was deeply troubled.
While GoPro said its Karma drone is the second-best-selling drone on the market, the company plans to exit the drone business after it sells its current inventory. GoPro attributed the move to challenging margins and a “hostile regulatory environment in Europe and the United States” that have made the drone business “untenable.”
But, the company will still incur expenses related to the drones. Even though GoPro will no longer be producing the Karma drone, it says it intends to continue to provide service and support to Karma customers.
Much of the hit to revenue came from price cuts in drones. “As we noted in our November earnings call, at the start of the holiday quarter we saw soft demand for our HERO5 Black camera,” said GoPro founder and CEO Nicholas Woodman in a released statement.
He added, “Despite significant marketing support, we found consumers were reluctant to purchase HERO5 Black at the same price it launched at one year earlier. Our December 10 holiday price reduction provided a sharp increase in sell-through.”
What’s Next for the Company?
GoPro says that it expects its fourth quarter revenue to be $340 million, a roughly 37% decline over 2016 levels. Wall Street expected $472 million in sales, according to FactSet.
More details about GoPro’s financial health will be revealed in its fourth quarter and end of year report, which is expected in early February. Until then, a rally in the stock seems to be unlikely.
The expected short term weakness in the stock creates a trading opportunity.
To benefit from weakness, an investor could buy put options. But, high prices on put options suggests an alternative trading 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 GPRO
For GPRO, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell a January 19 $6.50 call for about $0.30 and buy a January 19 $7 call for about $0.10. This trade generates a credit of $0.20, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $20. The credit received when the trade is opened, $20 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $30. The risk is found by subtracting the difference in the strike prices ($50 or $0.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($20).
This trade offers a return of about 67% for a holding period that is about one week. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if GPRO is below $6.50 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 $30 for this trade in GPRO.
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.