The Chart Tells the Tale
Many analysts spend weeks analyzing financial statements. They might start with the company’s report that is filed with the Securities and Exchange Commission (SEC). The SEC reports present one view, but some analysts believe they can improve on that view.
They might begin with simple adjustments. These could include ignoring depreciation and other non-cash charges.
Non-cash charges are defined by Investopedia as “expenses that can be found in a company’s income statement, but unaccompanied by a corresponding cash outflow.
These are accounting expenses that can represent meaningful changes to a company’s financial standing without affecting short-term capital in any way. Depreciation, amortization, depletion, stock-based compensation and asset impairments are common non-cash charges that reduce earnings but not cash flows.”
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Then they might review footnotes and other parts of the filings, creating what they believe is a more accurate representation of the company. They then compare their valuation with the stock market price and determine whether the stock provides potential gains.
Other analysts simply look at a chart. They might see a price move like the one shown in the chart below.
This large up move must have a cause and a quick look at the news identifies the catalyst for the price move.
Earnings Explain the Chart
In an earnings snapshot from ZACKS, we learn that “Ciena (NYSE: CIEN) came out with quarterly earnings of $0.53 per share, beating the Zacks Consensus Estimate of $0.49 per share. This compares to earnings of $0.46 per share a year ago. These figures are adjusted for non-recurring items.
This quarterly report represents an earnings surprise of 8.16%. A quarter ago, it was expected that this developer of high-speed networking technology would post earnings of $0.35 per share when it actually produced earnings of $0.48, delivering a surprise of 37.14%.
Over the last four quarters, the company has surpassed consensus EPS estimates three times.
Ciena, which belongs to the Zacks Fiber Optics industry, posted revenues of $899.36 million for the quarter ended October 2018, surpassing the Zacks Consensus Estimate by 4.51%.
This compares to year-ago revenues of $744.45 million. The company has topped consensus revenue estimates four times over the last four quarters”
Zack’s analyst notes, “the sustainability of the stock’s immediate price movement based on the recently-released numbers and future earnings expectations will mostly depend on management’s commentary on the earnings call.”
The chart can help us understand the sustainability of the move.
The Potential For Follow Through
The longer term chart below shows a strong up trend.
The recent break out could be an initial up move and could be followed by more gains. A strategy to benefit from that could also consider risk. We look at a possible strategy next.
A Trade for Short Term Bulls
As with the ownership of any stock, buying CIEN could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for CIEN
For CIEN, the January 18 options allow a trader to gain exposure to the stock.
A January 18 $37 call option can be bought for about $0.70 and the January 18 $39 call could be sold for about $0.25. This trade would cost $0.45 to open, or $45 since each contract covers 100 shares of stock.
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 $45.
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 CIEN the maximum gain is $1.55 ($39 – $37 = $2.00; $2.00 – $0.45 = $1.55). This represents $155 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $45 to open this trade.
That is a potential gain of about 344% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.