How Earnings Set a Potential 82% Gain With Risk of Less Than $200
Trade summary: A bull call spread in Synaptics using the March 20 $85 call option which can be bought for about $3.50 and the March 20 $90 call could be sold for about $1.73. This trade would cost $1.77 to open, or $177 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $177. The maximum gain is $323 per contract. That is a potential gain of about 82% based on the amount risked in the trade.
Now, let’s look at the details.
Stocks often make large moves on earnings. Recently, Synaptics Inc. (Nasdaq: SYNA) reported earnings and the stock closed up more than 20% on the day after the announcement. It actually made a big move at the open that day.
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Management released earnings after the close last week and the stock gapped up 14% at the open the next day. Many traders will ignore a stock after a move like that assuming the probability of a continuation is low. They may be correct, but there are strategies that can limit risk and provide exposure to the stock.
The cause of the big move was the fact that the company reported better than expected earnings. According to MarketWatch, the company reported that “fiscal second-quarter net income of $19.8 million, or 58 cents a share, compared with $12.8 million, or 36 cents a share, in the year-ago period. Adjusted earnings were $2.04 a share. Revenue declined to $388.3 million from $425.5 million in the year-ago quarter.
Analysts surveyed by FactSet had forecast earnings of $1.45 a share on revenue of $354.9 million.
“Our December quarter was better than expected due to unusually strong demand for our PC products and from our largest mobile customer during the holiday season,” said Michael Hurlston, Synaptics president and chief executive, in a statement.
Synaptics expects fiscal third-quarter revenue of $330 million to $350 million, while analysts had forecast on revenue of $299.1 million.”
The stronger than expected earnings are good news. The stronger than expected outlook for the current quarter are also good news and that could explain the strong gains in the stock.
The weekly chart indicates that downside risks could be substantial. The stock made a large move after announcing earnings three months and the most significant support is at about $50, more than 35% below the recent prices.
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 SYNA
For SYNA, the March 20 options allow a trader to gain exposure to the stock. This trade will be open for about six weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
A March 20 $85 call option can be bought for about $3.50 and the March 20 $90 call could be sold for about $1.73. This trade would cost $1.77 to open, or $177 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $177.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in SYNA the maximum gain is $3.23 ($90- $85= $5; $5 – $1.77 = $3.23). This represents $323 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $177 to open this trade.
That is a potential gain of about 82% in SYNA based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
A Trade for Short Term Bulls
As with the ownership of any stock, buying SYNA could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.