This Stock Could Suffer As Earnings Fail to Boost Prices
Follow through can be very important for traders to consider when assessing stock market action. This means traders might want to see a few days of gains after a rally on earnings. Or, they may want to see only a small pullback on the day after the rally.
Seeing a sharp decline can be a cause for concern. The type of price action to consider as potentially bearish can be seen below in the chart of Dunkin’ Brands Group, Inc. (Nasdaq: DNKN). A rally on earnings was followed by a steep decline.
Dunkin’ Brands Group, Inc. is the well known franchisor of quick service restaurants serving hot and cold coffee and baked goods, as well as hard serve ice cream. The Company franchises restaurants under its Dunkin’ Donuts and Baskin-Robbins brands.
Zacks reported that the company, “…reported mixed results in third-quarter 2019, wherein earnings surpassed the Zacks Consensus Estimate but revenues lagged the same. Notably, this marked its eighth straight quarter of earnings beat. Following the earnings release, shares of the company increased 6.3%.
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Its adjusted earnings of 90 cents per share surpassed the consensus estimate of 81 cents by 11.1%. The bottom line also improved 8.4% on a year-over-year basis, driven by a rise in net income.
Revenues were up 1.7% year over year to $355.9 million but missed the consensus mark of $359 million. The top-line improvement was primarily owing to a rise in royalty income from higher system-wide sales at Dunkin’ U.S. and rental income growth. The revenue growth was partially offset by a decline in advertising fees and related income.
The company’s global system-wide sales rose 4.7% from the prior-year quarter. Its system-wide sales were favored by global store development, and comps growth at Dunkin’ U.S. and Dunkin’ International.”
The longer term chart of the stock shows a pull back from recent highs and a possible topping pattern forming. The stock is near support now and a break of support could result in a significant decline in the stock’s price.
Based on the pattern, a price target of $65 is reasonable and that price coincides with additional support. When multiple factors align at the same level, as we see in this case with both support and the pattern pointing to $65, traders often have more confidence in their analysis.
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 DNKN
For DNKN, we could sell a November 15 $75 call for about $2.35 and buy a November 15 $77.50 call for about $0.80. This trade generates a credit of $1.55, 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 $155. The credit received when the trade is opened, $155 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $95. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($155).
This trade offers a potential return of about 63% 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 DNKN is below $75 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 $95 for this trade in DNKN.