Benefiting After an Earnings Beat Sends This Stock Down
Traders often find that earnings numbers are less important than what the company’s management says in the call with analysts after the release of the numbers. That was true for Microchip Technology Incorporated (Nasdaq: MCHP) which recently delivered better than expected earnings.
In the most recent quarter, the company reported earnings per share (EPS) of $1.61. Analysts had expected EPS of $1.48. Revenue of $1.22 billion also topped analysts’ expectations which had been for revenue of $1.21 billion.
Bad News Looks Likely in the Future
But, management also delivered bad news. According to TheStreet.com,
“Microchip also guided for September quarter non-GAAP revenue of $1.474 billion to $1.55 billion and EPS of $1.65 to $1.83. Revenue guidance is entirely below a $1.59 billion consensus, and EPS guidance mostly below a $1.67 consensus.
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CEO Steve Sanghi claimed “several small factors” are starting to weigh. Namely:
- Order push-outs by customers that aren’t able to build finished products thanks to shortages/stretched lead times for passive components.
- Trade tensions, which are said to be making some customers, such as smaller Chinese hardware makers that could be impacted by U.S. tariffs, nervous about future demand.
- Weak sales to China’s ZTE (estimated to be about 1% of Microchip’s revenue), which just saw a ban on U.S. parts imports lifted.
- Plunging demand for cryptocurrency mining hardware. Though Sanghi said crypto-related sales only account for about 1% of its sales, he also suggested demand has fallen by “70% or more.”
How the Stock Reacted Sets Up a Trading Opportunity
This news sent the stock lower.
Traders now need to consider whether the break is the beginning of a down trend or a consolidation within the up trend that has been underway for months.
Given the company’s news, it is likely the start of a down trend. That would be in line with Morgan Stanley’s recent downgrade of the industry. As CNBC noted,
“Semiconductor stocks have soundly outperformed the market for years, but Morgan Stanley is now warning the red-hot sector has topped out.
The firm lowered its rating to cautious from in line for the semiconductor industry, citing rising chip inventory levels. The cautious ranking is Morgan Stanley’s lowest rating and means its analyst believes the sector will underperform the market over the next 12 to 18 months.
“The semiconductor cycle is showing signs of overheating. … Cyclical indicators are flashing red and any contraction in lead times and/or demand slowdown could lead to a significant inventory correction,” analyst Joseph Moore said in a note to clients Thursday.
“Furthermore, elevated inventory and stretched lead times leave no margin for error as any lead time adjustment or demand slowdown could drive a meaningful correction. Risk/reward is the poorest it has been in 3 years.”
This all indicates a bearish strategy in MCHP could be profitable.
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 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 MCHP
For MCHP, we could sell a September 21 $90 call for about $2 and buy an September 21 $92.50 call for about $1. This trade generates a credit of $1.00, 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 $100. The credit received when the trade is opened, $100 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $150. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($100).
This trade offers a potential return of about 66% 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 MCHP 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 $150 for this trade in MCHP.
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.