This Earnings Trade Can Create Triple Digit Income
Traders can find opportunities in almost any news. As an example of a trade that a sophisticated investor might spot, consider the possibility of creating income after an earnings report.
Recent news shows how this could be done. PR Newswire, recently reported,
“Universal Health Services, Inc. (NYSE: UHS) announced [recently] that its reported net income attributable to UHS was $97.2 million, or $1.10 per diluted share, during the third quarter of 2019 as compared to $171.7 million, or $1.84 per diluted share, during the comparable quarter of 2018.
Net revenues increased 6.6% to $2.822 billion during the third quarter of 2019 as compared to $2.649 billion during the third quarter of 2018.”
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Traders did not seem to like the news and the stock sold off on the announcement.
The report continued, “For the three-month period ended September 30, 2019, our adjusted net income attributable to UHS, as calculated on the attached Schedule of Non-GAAP Supplemental Information (“Supplemental Schedule”), was $176.3 million, or $1.99 per diluted share, as compared to $208.8 million, or $2.23 per diluted share, during the third quarter of 2018.
Included in our reported and our adjusted net income attributable to UHS is a pre-tax unrealized loss of $15.2 million, or $.13 per diluted share after-tax, during the third quarter of 2019, as compared to a pre-tax unrealized gain of $10.5 million, or $.09 per diluted share after-tax, during the third quarter of 2018.
These unrealized losses/gains, which are included in “Other (income) expense, net” on the accompanying consolidated statements of income, resulted from decreases/increases in the market value of shares of certain marketable securities held for investment and classified as available for sale.
As reflected on the Supplemental Schedule, included in our reported results during the third quarter of 2019, is an aggregate net unfavorable after-tax impact of $79.1 million, or $.89 per diluted share, resulting from an unfavorable after-tax impact of $74.6 million, or $.84 per diluted share, resulting from a $97.6 million provision for asset impairment.
The news prompted a pullback which comes after the stock appeared to form a potential double top on the weekly chart shown below.
The double top could indicate that the extended up trend in the stock is done and traders could now be selling the stock and looking for new opportunities in the sector.
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 UHS
For UHS, we could sell a January 17 $135 call for about $6.20 and buy a January 17 $140 call for about $3.40. This trade generates a credit of $2.80, 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 $280. The credit received when the trade is opened, $280 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $220. 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 ($280).
This trade offers a potential return of about 127% 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 UHS is below $135 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 $220 for this trade in UHS.