Earnings Deliver a Leap and Set Up a Potential 63% Gain
It is earnings season and that creates the possibility of trading opportunities. Earnings is news and that means analysts will be forced to reevaluate their price models. Managers of funds, from conservative pension funds to aggressive hedge funds, may change their positions based on the news.
This makes earnings season an ideal time for short term traders to spot opportunities.
News From Lear
Lear Corporation (NYSE: LEA) designs, develops, engineers, manufactures, assembles, and supplies automotive seating, and electrical distribution systems and related components primarily to automotive original equipment manufacturers worldwide.
The Seating segment includes seat systems and related components, such as leather and fabric products, seat trim covers, recliner mechanisms, seat tracks, seat structures and mechanisms, seat foams, and headrests primarily for automobiles and light trucks, compact cars, and sport utility vehicles, as well as thermoelectric seat heating and cooling systems.
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The E-Systems segment offers electrical distribution systems that route electrical signals and manage electrical power within the vehicle for traditional vehicle architectures, as well as high power and hybrid electric systems.
This segment’s products include wire harnesses, terminals and connectors, and junction boxes; and electronic control modules, such as body control modules, smart junction boxes, gateway modules, wireless control modules, lighting control modules and audio domain controllers, and amplifiers, as well as associated software.
It also offers wireless systems comprising passive entry, remote keyless entry, and dual range/dual function remote keyless entry systems.
The company recently released earnings. According to an earnings snapshot released by Associated Press, Lear Corp. reported fourth-quarter profit of $212.2 million.
On a per-share basis, the company said it had profit of $3.39. Earnings, adjusted for non-recurring costs, were $4.05 per share.
The results surpassed Wall Street expectations. The average estimate of seven analysts surveyed by Zacks Investment Research was for earnings of $3.96 per share.
The automotive seating and electrical distribution systems company posted revenue of $4.94 billion in the period, falling short of Street forecasts. Four analysts surveyed by Zacks expected $4.98 billion.
For the year, the company reported profit of $1.15 billion, or $17.22 per share. Revenue was reported as $21.15 billion.
Lear expects full-year revenue in the range of $20.9 billion to $21.7 billion.
The stock price jumped on the news.
This price move potentially completes a short-term bottoming pattern and the break above nearby resistance could set the stock up for further gains.
A Trade for Short Term Bulls
As with the ownership of any stock, buying LEA could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for LEA
For LEA, the February 15 options allow a trader to gain exposure to the stock.
A February 15 $160 call option can be bought for about $3.70 and the February 15 $165 call could be sold for about $1.80. This trade would cost $1.90 to open, or $190 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $190.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in LEA the maximum gain is $3.10 ($165 – $160 = $5.00; $5.00 – $1.90 = $3.10). This represents $310 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $190 to open this trade.
That is a potential gain of about 63% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.