Good News Doesn’t Help This Tech Company
Earnings season can be puzzling to traders. Many traders expect a general pattern to emerge with good news of an earnings beat or better than expected revenue or an increase in the outlook for the future resulting in a gain in the stock price.
On the other hand, many traders expect bad news to result in a stock decline. Bad news could be earnings that are below the expectations of analysts, revenue that misses analysts’ expectations or reduced guidance for the next quarter or for the year.
However, there are times when the pattern is not followed. Fortunately for traders, there are trading strategies that allow them to benefit no matter which way the stock price reacts to news. One example of an unexpected decline in the face of good news unfolded in the stock of a software developer.
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The company posted fiscal first-quarter net income of $505 million, or $1.21 a share, down from $942 million, or $2.29 a share, in the comparable year-earlier period. The latest first quarter includes an unexpected gain of $132 million from VMware’s investment in Pivotal Software, the company said.
Revenue came in at $2.26 billion vs. $2.01 billion a year earlier.
On a non-GAAP basis, the company earned $553 million, or $1.32 a share, on revenue of $2.27 billion. Analysts polled by FactSet were expecting earnings of $1.28 a share and revenue of $2.24 billion.
VMware, a Dell Technologies portfolio company, said license revenue for the quarter was $869 million. Operating cash flows came to $1.27 billion, while free cash flows for the quarter were $1.2 billion.
In terms of guidance, VMware is maintaining its fiscal 2020 forecast, with expected revenue of $10.03 billion. Analysts are expecting revenue of $10.02 billion with earnings of $6.53 a share.
VMware also said that its board has authorized up to $1.5 billion in stock repurchases through fiscal 2021.
Any of these factors could be viewed as bullish however the market reacted as if the outlook is bearish and the pattern indicates that weakness could persist for at least a few weeks.
The large move down could be a break out, to the down side, after VMW spent weeks in consolidation.
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 VMW
For VMW, we could sell a July 19 $175 call for about $10.75 and buy a July 19 $180 call for about $8. This trade generates a credit of $2.75, 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 $275. The credit received when the trade is opened, $275 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $270. 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 ($275).
This trade offers a potential return of about 101% 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 VMW is below $45 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 $270 for this trade in VMW.