Campbell Soup Misses Earnings and a Trading Opportunity Appears
When a large company misses its earnings estimates, the story tends to generate headlines. The headlines capture the attention of traders. The traders then react to the news and the stock often becomes more volatile than usual.
It is the increase in volatility that then becomes the opportunity for more conservative traders. This is not surprising since the primary wave of business activity is the riskiest and businesses that seize the opportunity later tend to be profitable.
Consider the risks associated with some of the world’s most profitable businesses. Microsoft did not invent word processing software or spreadsheet software but it is now generating profits after the developers went bankrupt or sold out.
The same is true for Amazon which was not the first online book store. It wasn’t the first company to sell a variety of products through an online market place. But, again, it is now profitable after many competitors failed or sold out.
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We can see a similar process in trading at times. Earnings reports will often create volatility in individual stocks. Some traders take positions before the announcement to profit from the news. There is a risk with this strategy that the earnings will not be in line with the trader’s initial position.
Another strategy is to wait for the earnings report, allow the volatility in the stock to develop and then use options strategies designed to benefit from high volatility. That is the approach we will consider for Campbell Soup Company (NYSE: CPB).
Earnings Missed Expectations
In the most recent quarter, Campbell reported earnings per share (EPS) of $0.92. Analysts had expected $0.97. Reported revenue of $2.16 billion also missed Wall Street estimates which had been for $2.17 billion.
“This was a difficult quarter, particularly for our U.S. soup business… The sales decline was the result of one key customer’s different promotional approach to the soup category for fiscal 2018,” Chief Executive Denise Morrison said.
It’s obvious to traders that this is a problem that involves more than just one quarter. Campbell also cut its fiscal 2018 adjusted profit to $2.95 to $3.02 per share from previously stated $3.04 to $3.11. The reduced outlook put the company’s guidance well below the analysts’ average estimate of $3.05 per share.
Organic sales at the company’s largest division, Americas simple meals and beverages, fell 5%. The unit was hurt by a 9% drop in sales at its soup business in the United States as retailers stocked up fewer seasonal inventory of soups ahead of the winter season.
A decline in the demand for its V8 brand of beverages also weighed on the division’s organic sales.
The company also suffered from higher costs. Campbell’s gross margin, which is the amount of money left over from revenue after all expenses are paid, decline by 2.4% in the quarter compared to a year ago. The company blamed higher supply costs, especially the cost of carrots.
Gross margins were also affected by higher discounting as Campbell fought to match price competition from rivals including General Mills and Conagra.
Analysts expressed concern about the sector. “We expect the entire food group to trade off today on the back of this earnings release, but we remind investors that the two major problems (a lost promotion at Wal Mart, carrots) are CPB-specific,” J.P. Morgan analyst Ken Goldman said.
Trading the Trend
The trend in the stock is now likely to be down, at least the next few weeks. As the chart of weekly data below shows, the market action has been bearish for more than six months.
The next chart is a daily chart and shows the most recent decline appears to signal a down side break out from a two month consolidation.
That trend is likely to endure until there is a significant change in the company’s news. This could come in late February when the company provides the next quarterly report.
This indicates traders who want to trade the trend in Campbell should consider trades that are benefit from moves to the down side.
To benefit from weakness, an investor could buy put options. But, as the chart shows, Campbell has been in a downtrend and that has resulted in increased volatility. The higher volatility increases options premiums even more. This is normal behavior when a sell off occurs.
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 Campbell
For Campbell, we have a number of options available. Short term options allow us to trade frequently and potentially 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 December 15 $48 call for about $0.60 and buy a December 15 $50 call for about $0.20. This trade generates a credit of $0.40, 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 $40. The credit received when the trade is opened, $40 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $160. The risk is found by subtracting the difference in the strike prices ($200 or $2.00 time 100 since each contract covers 100 shares) and then subtracting the premium received ($40).
This trade offers a return of about 25% for a holding period that is less than one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if Campbell is below $48 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 $160 for this trade in Campbell.
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.