Low Earnings Should Interest Individual Traders
As traders, it’s common to read earnings reports and the size of the numbers in the reports can be setting unrealistic expectations. For example, we might see something like, “Amazon reported first-quarter profit of $3.6 billion on sales of $59.7 billion.”
Then, we might ignore headlines like “Proto Labs Inc. (NYSE: PRLB) reported first-quarter earnings of $15.5 million.”
Protol Labs claims to be “the world’s fastest digital manufacturing source for rapid prototyping and on-demand production.
The technology-enabled company produces custom parts and assemblies in as fast as one day with automated 3D printing, CNC machining, sheet metal fabrication, and injection molding processes.
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Its digital approach to manufacturing enables accelerated time to market, reduces development and production costs, and minimizes risk throughout the product life cycle.”
But PRLB could be interesting to traders, as the Associated Press reported,
“On a per-share basis, the company said it had net income of 57 cents. Earnings, adjusted for stock option expense and non-recurring costs, came to 69 cents per share.
The results did not meet Wall Street expectations. The average estimate of three analysts surveyed by Zacks Investment Research was for earnings of 70 cents per share.
The custom parts manufacturer posted revenue of $113.5 million in the period, also missing Street forecasts. Three analysts surveyed by Zacks expected $115.7 million.
“In the first quarter of 2019, the headwinds described in our Q1 outlook were greater than anticipated, including a decline in our acquired services,” said John Way, Chief Financial Officer. “The organization is focused on actions to improve the performance of this business, delivering differentiated services to our customers.”
Victoria M. Holt, President and Chief Executive Officer, added, “The revenue and the earnings growth from our acquisition of Rapid Manufacturing did not meet our expectations this quarter.
As we discussed in our earnings call on February 7, we did not experience the increase in demand for the acquired sheet metal and expanded CNC services, when we began selling these services to the legacy Proto Labs customers on January 1.
In fact, the revenue from the services produced in the acquired facilities declined $2.5 million or 21% compared to the first quarter of 2018.
As we discussed in the fourth quarter earnings call, when we integrated the two sales teams, we distributed accounts and disrupted the entire sales organization by realigning accounts to allow our customers to be managed by one account manager rather than two.”
Traders seemed to view the news as bullish and selling pressure developed in the stock.
This could be an indication the company faces long term pressures since management noted they had talked about the problems in previous calls. The stock has been in a down trend for months and that could continue.
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 PRLB
For PRLB, we could sell a May 17 $105 call for about $5 and buy a May 17 $110 call for about $2.27. This trade generates a credit of $2.73, 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 $273. The credit received when the trade is opened, $273 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $227. 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 ($273).
This trade offers a potential return of about 20% 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 PRLB is below $105 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 $227 for this trade in PRLB.