Here’s a Trade to Prepare for Earnings
Earnings season generates trading opportunities. Although this quarter the opportunities have been below average. The earnings numbers have been good, but the market reaction has been subdued.
According to FactSet, a research firm for professional investors:
“Market Not Rewarding Earnings Beats and Not Punishing Earnings Misses.
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To date, the market is rewarding upside earnings surprises less than average and punishing downside earnings surprises less than average.
Companies that have reported upside earnings surprises for Q1 2018 have seen an average price increase of 0.4% two days before the earnings release through two days after the earnings. This percentage increase is well below the 5-year average price increase of +1.1% during this same window for companies reporting upside earnings surprises.
Companies that have reported downside earnings surprises for Q1 2018 have seen an average price decrease of -1.5% two days before the earnings release through two days after the earnings. This percentage decrease is much smaller than the 5-year average price decrease of -2.4% during this same window for companies reporting downside earnings surprises.”
Trading Earnings in a Below Average Season
Traders have a variety of strategies available to them during earnings season. If they have a directional call in mind, for example, if they expect a strong earnings report to be followed by a large up move in the stock, they could buy call options.
Likewise, buying put options could benefit from a large expected decline in the stock price on a negative earnings report. Traders who are uncertain about the direction but who expect a large price move could use a strangle or a straddle. A straddle carries a high degree of risk and may not be right for many traders.
This quarter, it seems that stocks may make less than average moves. But, options prices will often be based on an average move or even a larger than average price move. That creates trading opportunities in some stocks.
In particular, Macy’s, Inc. (NYSE: M) is a potential trading opportunity. Options prices are reflecting the probability of a larger than average move and that creates an opportunity to generate income.
A Strategy to Benefit While Waiting for the News
For Macy’s, there is a relatively high likelihood of a relatively narrow trading range. One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in Macy’s
For Macy’s, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, May 18.
The difference in the exercise prices of the calls or puts is equal to $1.50. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $150 less the premium received when the trade was opened.
Selling the options will generate $1.31 in income ($0.82 from the call and $0.49 from the put). Buying the options will cost $0.75 ($0.49 for the call and $0.26 for the put). This means opening the trade will result in a credit of $0.56, or $56 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($1.50) minus the premium received ($0.56). This is equal to $0.94, or $94 since each contract covers 100 shares. Many brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $94 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $0.56 or $56 per contract.
The potential reward on the trade ($56) is about 60% of the amount risked, a high potential return on investment for a trade that will be open for about three weeks. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
This trade could also be closed out early to reduce the potential risks of the trade. It could still deliver its maximum gain even if the position is closed before the expiration date of the options.
The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.