Disappointments Can Be Profitable
Earnings estimates are prepared after careful analysis by Wall Street analysts who spend a great deal of time collecting information and reviewing data. The models are built to reflect the specialized expertise the analysts develop, and the data collection process is also refined over time.
Despite all of this work, and the millions of dollars spent by large firms to have personnel complete the work, the estimates are almost always wrong. In a typical quarter, about 70% of the earnings reports will be better than analysts’ expectations and about 70% will deliver better than expected sales.
Another 20%, or so, of companies will come in with earnings or sales that fail to meet expectations. In a typical quarter, it is common to see less than 10% of the reports come in exactly in line with the estimates.
This creates trading opportunities since investors will have to react to the new information.
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AbbVie Misses Expectations and Bears Pounce
AbbVie Inc. (NYSE: ABBV) is a research-based biopharmaceutical company. The company is engaged in the discovery, development, manufacture and sale of a range of pharmaceutical products.
Its products are focused on treating conditions, such as chronic autoimmune diseases in rheumatology, gastroenterology and dermatology; oncology, including blood cancers; virology, including hepatitis C virus (HCV) and human immunodeficiency virus (HIV); neurological disorders, such as Parkinson’s disease and multiple sclerosis; metabolic diseases, including thyroid disease and complications associated with cystic fibrosis, and other serious health conditions.
It offers products in various categories, including HUMIRA (adalimumab), Oncology products, Virology Products, Additional Virology products, Metabolics/Hormones products, Endocrinology products and other products, which include Duopa and Duodopa (carbidopa and levodopa), Anesthesia products and ZINBRYTA (daclizumab).
TheStreet reported that shares of ABBV fell after the company reported fourth-quarter results below analysts’ consensus forecasts.
The company reported fourth-quarter earnings of $1.90 a share on revenue of $8.305 billion. Analysts were looking for earnings of $1.93 on revenue of $8.37 billion.
“We’re entering an important new phase for AbbVie. The continued momentum of our business, combined with the launch and ramp of several new products, will allow us to drive strong earnings growth once again in 2019 and position us for growth over the longer term,” said CEO Richard Gonzalez.
Revenue in the quarter rose 7.3% year over year thanks in part to a 50% increase in the company’s global hematologic oncology portfolio where net revenue was $1.13 billion.
AbbVie issued full-year adjusted earnings guidance of between $8.65 and $8.75 a share, which represents 10% growth over 2018 at the mid-point.
“We delivered exceptional performance in 2018, including operational revenue growth of more than 15% and EPS growth above 40%,” Gonzalez said.
The company also announced that its board of directors authorized a $5 billion increase in the company’s existing stock repurchase program. The program has no time limit and may be discontinued at any time.
The down move potentially breaks support and could be followed by additional losses in the stock price.
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.
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 ABBV
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.
For ABBV, we could sell a February 15 $80 call for about $2.20 and buy a February 15 $82.50 call for about $1.05. This trade generates a credit of $1.15, 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 $115. The credit received when the trade is opened, $115 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $135. 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 ($115).
This trade offers a potential return of about 85% 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 ABBV is below $80 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 $135 for this trade in ABBV.