Market Trends Foreshadow Earnings
Foreshadowing is a literary device a writer uses to drop hints about what will come later in the story. William Shakespeare frequently used this technique in his plays.
In Romeo and Juliet, in the famous balcony scene, Juliet expresses concerns about Romeo’s safety because she worries that her family could catch him. Romeo says, in Shakespeare’s more flowery language, that he would rather have her love and die than live without Juliet.
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If you’re familiar with that story, you know that Romeo wins his Juliet and they both lose their lives over that love.
Foreshadowing is not confined to literature. It’s also often seen in the stock market. In this case, it’s often that the trend is in place before the news is revealed.
For example, we tend to be in down trends when bad news is announced. In the broad market, we tend to be in a down trend by the time economists announce that a recession has already started. In specific stocks, we are often in a down trend when a company announces that earnings will be lower than expected.
The same pattern is seen for good news. The broad market generally turns up before the economists are convinced that the economy has started growing again. For individual stocks, prices are often rallying when a company delivers better than expected earnings.
News Confirms the Trend, Again
This week, Tupperware Brands Corp. (NYSE: TUP) lowered its first quarter earnings and sales guidance. The company said it expects revenue to fall by about 2%, which is 3% lower than the low end of its previous guidance which included an increase in sales.
Management also now expects earnings per share to be within a range of $0.87 to $0.92, a significant decline from earlier guidance of $1.01 to $1.06 a share for the current quarter. The company told analysts it will provide a more complete update to its guidance when it releases earnings April 25.
Among other factors for the lower guidance, Tupperware cited a $0.06 cent per share impact from U.S. tax reform and, perhaps more importantly, customer service issues in Europe.
Before the announcement, the stock had already been moving lower.
This down trend began a year ago although the stock reached its all time high more than four years ago.
That’s significant because it indicates many investors who bought TUP shares in the past few years now show a loss. The stock is now at levels last seen in 2011. This means selling pressure is likely to continue as investors take losses on long term positions.
In the short run, there is unlikely to be a significant rally in TUP. It will take time for traders to gain confidence that the company is recovering from its problems. That creates a trading opportunity.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook, a call option should be sold.
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 is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in TUP
For TUP, we have a number of options available. Short term options allow us to trade frequently and potentially our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell an May 18 $45 call for about $1.00 and buy an May 18 $50 call for about $0.15. This trade generates a credit of $0.85, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $85. The credit received when the trade is opened, $0.85 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $415. The risk is 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 ($85).
This trade offers a potential return of about 20% of the amount risked for a holding period that is about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if TUP is below $45 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 $415 for this trade in TUP.
These are the type of best option strategy that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.