Earnings Set Up a Potential Gain of More Than 50%
Many companies describe what they do in positive terms. For example, Tenneco Inc. (NYSE: TEN) is “a producer of clean air and ride performance products and systems for light vehicle, commercial truck, off-highway and other vehicle applications.” This sounds appealing.
But traders often ignore appealing descriptions and buy or sell based on news. In this case, they recently sold after the company announced earnings.
A Loss Surprises the Street
For TEN, Associated Press reported an earnings snapshot:
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“[the company] reported a fourth-quarter loss of $109 million, after reporting a profit in the same period a year earlier.
On a per-share basis, the Lake Forest, Illinois-based company said it had a loss of $1.35. Earnings, adjusted for one-time gains and costs, were $1.30 per share.
The results fell short of Wall Street expectations. The average estimate of eight analysts surveyed by Zacks Investment Research was for earnings of $1.43 per share.
The auto parts maker posted revenue of $4.28 billion in the period, which met Street forecasts.
For the year, the company reported profit of $55 million, or 93 cents per share. Revenue was reported as $11.76 billion.”
A Clouded Outlook
Looking ahead, Business Wire reported,
Tenneco expects full-year revenue in the range of $18.2 billion to $18.4 billion. This comes after the company completed acquisition of Federal-Mogul on October 1, 2018 and is now on track to achieve acquisition synergy goals.
For the future, “On a pro forma basis, the company expects constant dollar revenue to be about even with last year, outpacing a forecasted light vehicle production decline of 6% in the first quarter.
“In 2019, we expect continued revenue growth that outpaces global industry production, powered by diverse and sustainable growth drivers across our business,” said Roger Wood, Tenneco co-CEO.
“Our global teams are executing well against the integration plans and are on track to fully achieve our financial synergy targets for earnings and working capital.”
But, the bullishness of the co-CEO may not be shared by traders. Selling after earnings seemed to end the brief rally in the stock and the price is now near its 52-week lows.
Based on the weekly chart shown above, the path of least resistance in the short term appears to be down.
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.
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 TEN
For TEN, we could sell an April 18 $27 call for about $1.00 and buy an April 18 $29 call for about $0.32. This trade generates a credit of $0.68, 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 $68. The credit received when the trade is opened, $68 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $132. The risk can be found by subtracting the difference in the strike prices ($200 or $2.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($68).
This trade offers a potential return of about 51% 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 TEN is below $27 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 $130 for this trade in TEN.