Sometimes, An Earnings Beat Isn’t Enough
Source: Red Hat.com
Traders know that earnings can be market moving. They also know that the direction and the magnitude of the market move can be surprising. It’s possible, some traders might even say that it’s common, for a company to beat earnings expectations and the stock sells off.
This could be because the size of the beat did not meet the elevated expectations of analysts or because the management included a less bullish outlook in their earnings announcement. In the case of Red Hat (NYSE: RHT), the latter reason drove a sharp sell off in the stock.
A Strong Report, and a Negative Reaction
RHT reported earnings per share (EPS) of $0.72, four cents better than the Zacks Consensus Estimate. The figure increased 24% on a year-over-year basis, primarily driven by strong top-line growth.
Revenues increased 20% year over year to $814 million, primarily driven by strong demand for hybrid cloud technology solutions as well as aggressive cross-selling. The figure was better than the Zacks Consensus Estimate of $807 million.
But, looking ahead for the full year, “management forecasts revenues in the range of approximately $3.375-$3.410 billion, down from previous guidance range of $3.425-$3.460 billion, primarily due to the negative impact from a strong U.S. dollar.
Moreover, weakness in middleware, primarily due to ongoing workload shifting from legacy physical deployments to container environments, is expected to hurt top-line growth this fiscal.
Non-GAAP operating margin is anticipated to be 23.9%. Red Hat now expects fiscal non-GAAP earnings between $3.44 and $3.48, better than previous guidance range of $3.38-$3.41 per share. This is primarily due to lower effective tax rate.
Operating cash flow is expected to be in a range of $1.035-$1.045 billion.”
Traders were disappointed with the guidance and the stock sold off.
MarketWatch.com provided a summary of the news, “”Fiscal 2019 guidance was lowered by 2 points of growth, due entirely to greater FX headwinds,” wrote Jefferies analyst John DiFucci.
“Red Hat has made strides in becoming more than just a Linux company, but a quarter like this poses the question of ‘How much more?'” He has a hold rating and $154 target on the stock.
Monness, Crespi, Hardt, and Co. analyst Brian White lowered his price target to $186 from $200, but he recommended that investors buy the dip. “We have seen Red Hat stumble before (e.g., end of 2016) and regain its balance shortly thereafter, before continuing its journey down the open source highway,” White wrote.”
The decline marks a significant reversal from the stock’s previous strong up trend.
Investors with a focus on the long term must decide whether they expect the stock to bounce back in the long run. Traders with a short term focus can generate from the fact that the stock is unlikely to make a significant up move in the short term.
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 RHT
For RHT, we have a number of options available. Short term options allow us to trade frequently and potentially expand 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 a July 20 $145 call for about $0.45 and buy a July 20 $170 call for about $0.15. This trade generates a credit of $0.30, 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 $30. The credit received when the trade is opened, $30 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $470. 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 ($30).
This trade offers a potential return of about 6.4% of the amount risked for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if RHT is below $145 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 RHT.
These are the type of strategies 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.