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Disappointment Leads to a Trading Opportunity

Disappointment Leads to a Trading Opportunity

Many investors like to see better than expected earnings. But traders could also benefit from the announcements that reveal disappointing earnings. This was the case, as PR Newswire reported, when a biotech reported earnings.

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  • “Penumbra, Inc. (NYSE: PEN), a global healthcare company focused on innovative therapies, today reported financial results for the third quarter ended September 30, 2019.

    Revenue of $139.5 million in the third quarter of 2019, an increase of 24.8%, or 25.5% in constant currency, over the third quarter of 2018.”

    The news triggered selling.

    PEN daily chart

    The report continued, “Total revenue grew to $139.5 million for the third quarter of 2019 compared to $111.8 million for the third quarter of 2018, an increase of 24.8%, or 25.5% on a constant currency basis.

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  • The United States represented 65% of total revenue and international represented 35% of total revenue for the third quarter of 2019. Revenue from sales of neuro products grew to $83.2 million for the third quarter of 2019, an increase of 11.5%, or 12.4% on a constant currency basis.

    Revenue from sales of vascular products grew to $56.3 million for the third quarter of 2019, an increase of 51.6%, or 52.0% on a constant currency basis.

    Gross profit was $96.0 million, or 68.8% of total revenue, for the third quarter of 2019, compared to $75.0 million, or 67.1% of total revenue, for the third quarter of 2018.

    Total operating expenses for the third quarter of 2019 were $83.0 million, or 59.5% of total revenue.

    This compares to total operating expenses of $95.9 million, or 85.7% of total revenue, for the third quarter of 2018, which included a $30.8 million acquired in-process research and development (“IPR&D”) charge in connection with the acquisition of a controlling interest in MVI Health Inc.

    Excluding the IPR&D charge, total adjusted operating expenses2 (a non-GAAP measure) were $65.0 million, or 58.2% of total revenue, for the third quarter of 2018. R&D expenses were $13.7 million for the third quarter of 2019, compared to $9.1 million for the third quarter of 2018. SG&A expenses were $69.3 million for the third quarter of 2019, compared to $55.9 million for the third quarter of 2018.

    Operating income for the third quarter of 2019 was $13.0 million. This compares to an operating loss of $20.8 million for the third quarter of 2018, including the IPR&D charge. Excluding the IPR&D charge, adjusted operating income2 (a non-GAAP measure) was $10.0 million for the third quarter of 2018.”

    The news comes as the stock faced resistance.

    PEN weekly chart

    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.

    bear call spread

    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.

    Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.

    When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.

    A Bear Call Spread in PEN

    For PEN, we could sell a December 20 $165 call for about $7.28 and buy a December 20 $170 call for about $5.50. This trade generates a credit of $1.78, 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 $178. The credit received when the trade is opened, $178 in this case, is also the maximum potential profit on the trade.

    The maximum risk on the trade in PEN is about $322. 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 ($178).

    This trade in PEN offers a potential return of about 55% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if PEN is below $165 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 $322 for this trade in PEN.

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