High Volatility Can Create Triple Digit Income
Trade summary: A bear call spread in FLIR Systems, Inc. (Nasdaq: FLIR) using April 17 $42 call options for about $5.72 and buy an April 17 $46 call for about $3.02. This trade generates a credit of $2.70 which is the difference in the amount of premium for the call that is sold and the call.
In this trade, the maximum risk is about $130. The risk can be found by subtracting the difference in the strike prices ($400 or $4.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($270). This trade offers a potential return of about 107% of the amount risked.
Now, let’s look at the details.
FLIR fell after the company reported earnings that were below expectations.
ZACKS reported that the company announced “fourth-quarter 2019 adjusted earnings of 55 cents per share missed the Zacks Consensus Estimate of 62 cents by 11.3%. The reported figure also declined 11.3% from the 62 cents registered in the prior-year quarter.
Excluding the one-time items, the company reported GAAP earnings of a penny compared with the earnings of 71 cents recorded in the year-ago quarter.
The company’s 2019 adjusted earnings of $2.23 per share missed the Zacks Consensus Estimate of $2.30 by 3%. However, the reported figure edged down 0.5% from the prior-year tally of $2.22.
FLIR Systems’ revenues increased 9% year over year to $489 million in the reported quarter. Improved sales performance of the Industrial and Government and Defense business segments primarily resulted in this year-over-year top-line growth. The top line, however, missed the Zacks Consensus Estimate of $500.2 million by 2.2%.”
The announcement also included management’s updated guidance for 2020. Zacks noted, “The company projects adjusted earnings per share at $2.10-$2.30 on revenues of $1.85-$1.925 billion.
Currently, the Zacks Consensus Estimate for 2020 earnings is pegged at $2.56 on revenues of $2 billion. Both earnings and revenue estimates come in above the projected range of the company’s guidance.”
Guidance that is lower than analysts’ expectations are bearish and with weakness in the broad market FLIR is unlikely to move higher. The chart below uses weekly data and shows the stock’s recent rally failed at resistance.
FLIR peaked in 2018 and has been unable to reach new highs as the broad stock market did. The stock’s relative underperformance is another factor contributing to potential weakness in the stock.
The weight of the evidence in FLIR is bearish however a broad market rally could affect all stocks and drive FLIR higher despite the weak technicals. Risk management strategies could be ideal to profit in this environment.
Buying shares of the stock exposes traders to significant risks in dollar terms. A spread trade with options allows traders to obtain exposure to the stock with a defined level of risk. That strategy is explained in detail below, at the end of this article.
A Specific Trade for FLIR
For FLIR, we could sell an April 17 $42 call for about $5.72 and buy an April 17 $46 call for about $3.02. This trade generates a credit of $2.70, 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 $270. The credit received when the trade is opened, $270 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $130. The risk can be found by subtracting the difference in the strike prices ($400 or $4.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($270).
This trade offers a potential return of about 107% 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 FLIR is below $42 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 $199 for this trade in FLIR.
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.