Good News Fails to Deliver a Breakout
Some news seems good but the market reaction to the news fails to confirm that impression. At times like that, some traders like to use a strategy that creates income while they wait for a more decisive move in the stock. News from Carpenter Technology (NYSE: CRS) sets up that kind of trade.
Earnings Seem Good
ZACKS reported on the company’s recent earnings announcement:
“Carpenter Technology came out with quarterly earnings of $0.76 per share, beating the Zacks Consensus Estimate of $0.66 per share. This compares to earnings of $0.55 per share a year ago. These figures are adjusted for non-recurring items.
This quarterly report represents an earnings surprise of 15.15%. A quarter ago, it was expected that this maker of stainless steels and special alloys would post earnings of $0.75 per share when it actually produced earnings of $0.65, delivering a surprise of -13.33%.
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Over the last four quarters, the company has surpassed consensus EPS estimates three times.
Carpenter… posted revenues of $556.50 million for the quarter ended December 2018, missing the Zacks Consensus Estimate by 2.48%. This compares to year-ago revenues of $487.80 million. The company has topped consensus revenue estimates three times over the last four quarters.”
Commentary from GlobeNewswire also seemed bullish:
“Our quarter results mark our best second quarter performance since fiscal year 2013 as solid commercial execution and market demand patterns drove strong financial results,” said Tony Thene, Carpenter Technology’s President and CEO.
“Our broad market diversity and solutions-focused approach is unlocking new customer and market opportunities, which is demonstrated by our backlog growing 16% sequentially and 49% year-over-year.”
“Overall, demand levels across our end-use markets remain strong and four of our five end-use markets delivered year-over-year revenue growth. This includes Aerospace and Defense where we continue to benefit from our broad industry participation and the ongoing industry ramp. In addition, we are capturing incremental market share in the Medical end-use market through expanded relationships with leading industry OEMs who increasingly recognize the value of our high-end solutions.”
“Moving forward, our focus remains centered on the continued execution of our commercial strategy, unlocking incremental capacity via the Carpenter Operating Model and investing in the future.
In the current quarter, we received three additional qualifications for our Athens facility and we continue to work closely with customers on advancing remaining qualifications for the facility, which represents the potential for incremental capacity for the industry.
We also continue to focus on expanding our leadership position in additive manufacturing and soft magnetics where we are leveraging our healthy balance sheet to further expand our core capabilities. The investments we are making are critical to strengthening our long-term growth profile and ensuring our position as an irreplaceable solutions provider for our customers.”
The stock did seem to initially respond to the news, but failed to follow through.
It now seems possible the stock could resume the long term down trend that can be seen in the longer term 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.
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 CRS
For CRS, we could sell a March 15 $45 call for about $2.10 and buy a March 15 $50 call for about $0.45. This trade generates a credit of $1.65, 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 $165. The credit received when the trade is opened, $165 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $335. 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 ($165).
This trade offers a potential return of about 49% 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 CRS 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 $170 for this trade in CRS.