Tax Reform Leaves Winners and Losers
Tax reform has been an important topic of conversation for traders in the past few months. First, there was speculation about the size of the impact the new tax rules would have. Then, as earnings were announced, analysts were forced to raise earnings estimates as the impact of reform became clear.
Changes to the tax rules led to a surge in earnings and many stocks are trading higher as a result of the process. But, not all stocks are winners. Some are facing significant adverse changes in their business plans because of simplified taxes.
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H&R Block, Inc. (NYSE: HRB) plunged after the company reported earnings and management updated its outlook for the current year. It was the outlook that presented the challenge to investors.
A Good Look Back, A Rocky Look Ahead
According to The Wall Street Journal, net income for the quarter was $1.14 billion, or $5.42 a share, compared with $783.4 million, or $3.75 a share, for the same quarter a year before. Analysts polled by FactSet were looking for $5.23 cents a share.
Total revenues for the quarter rose about 2.6% to $2.39 billion, ahead of the consensus forecast of $2.34 billion.
For fiscal 2018, about 20 million returns were prepared by or through H&R Block in the U.S., a 2.5% increase over fiscal 2017. The company’s U.S. assisted business had a 0.6% decline in returns compared to a 2.5% decline in fiscal 2017. Online returns rose 10.3%.
The company announced a dividend increase to an annual rate of $1, or 25 cents per quarter, representing a 4 percent increase over the prior year
These were all good indicators for the company.
But, in the conference call with analysts that came after the earnings were released, management said they expected this year’s revenue would fall between $3.05 billion and $3.1 billion, while analysts were looking for $3.14 billion. This would also represent a drop from fiscal 2018’s $3.16 billion.
The company indicated that it intends to be a bit more aggressive on pricing, which is the primary reason for the reduced guidance. Analysts believed this could be due to the new U.S. tax code, which is generally simpler than in prior years, giving the company less pricing power.
Some noted “that when Americans have simpler tax returns, tax preparers like H&R Block can’t get away with charging as much to prepare them.
Just to name one area of complexity, roughly 20% of Americans in 2017 and prior tax years benefited from itemized deductions, which requires a more complex preparation method. Going forward, this figure is expected to drop to just 5% as more people opt for the standard deduction.”
Traders have been pricing a negative trend into the stock for some time.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a short term rebound in HRB seem to be remote. Traders should consider using an options strategy known as a bear put spread to benefit from the expected downward price move.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for HRB
The bearish outlook for HRB, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the options expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the July 20 $23 put can be bought for about $0.30 and the July 20 $22 put can be sold for about $0.10. This trade will cost about $0.20 to enter, or $20 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
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 $20. This loss would be experienced if HRB is above $23 when the options expire. In that case, both options would expire worthless.
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 HRB, the maximum gain is $0.80 ($23 – $22 = $1.00; $1.00 – $0.20 = $0.80). This represents $80 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $20 to open this trade.
That is a potential gain of about 300% of the amount risked in the trade. This trade delivers the maximum gain if HRB closes below $22 on July 20 when the options expire.
Put 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 $20 for this trade in HRB.