Losses Matter, Sometimes
Trade summary: A bear call spread in Varonis Systems, Inc. (Nasdaq: VRNS), using March 20 $85 call options for about $6.40 and buy a March 20 $90 call for about $3.40. This trade generates a credit of $3.00, 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 $200. 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 ($300). This trade offers a potential return of about 50% of the amount risked.
Now, let’s look at the details.
Varonis Systems (Nasdaq: VRNS) came out with a quarterly loss of $0.09 per share according to ZACKS. This compares to earnings of $0.54 per share a year ago. These figures are adjusted for non-recurring items.
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This quarterly report represents an earnings surprise of 10%. A quarter ago, it was expected that this data-management software company would post a loss of $0.34 per share when it actually produced a loss of $0.16, delivering a surprise of 52.94%.
Over the last four quarters, the company has surpassed consensus EPS estimates three times.
Varonis posted revenues of $72.56 million for the quarter ended December 2019. This compares to year-ago revenues of $87.52 million. The company has topped consensus revenue estimates two times over the last four quarters.”
The stock was up on the news.
GlobeNewswire reported that Guy Melamed, Varonis CFO and COO, said, “2019 was a transformational year, capped by our fourth quarter results, in which we achieved a record 82% of license revenues from subscriptions and ended with annual recurring revenues of $210.5 million, up 62% year-over-year.”
But, the company still lost money. VRNS is also expected to lose money this year and earn just $0.04 in fiscal year 2021. This is an expensive stock for a company that is losing money and even if it makes money next year, the P/E ratio is about 2,250.
Support near $80 could slow a fall, but a decline appears possible.
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 VRNS
For VRNS, we could sell a March 20 $85 call for about $6.40 and buy a March 20 $90 call for about $3.40. This trade generates a credit of $3.00., 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 $300. The credit received when the trade is opened, $300 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $200. 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 ($300).
This trade offers a potential return of about 50% 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 VRNS is below $85 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 $200 for this trade in VRNS.
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.