Traders Are Buying Large Cap Growth
Traders seem to be reacting well to earnings reports that beat expectations for large cap companies. And companies are providing ample opportunities for traders to benefit from news.
So far this quarter, according to FactSet, “81% of the companies in the S&P 500 have reported actual results for Q2 2018. In terms of earnings, more companies are reporting actual EPS above estimates (80%) compared to the 5-year average.”
That is a strong quarter. “If 80% is the final number, it will mark the highest percentage of S&P 500 companies reporting a positive EPS surprise for a quarter since FactSet began tracking this metric in Q3 2008.
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In aggregate, companies are reporting earnings that are 4.9% above the estimates, which is also above the 5-year average. In terms of sales, more companies (74%) are reporting actual sales above estimates compared to the 5-year average. In aggregate, companies are reporting sales that are 1.4% above estimates, which is also above the 5-year average.”
And, from a trading perspective, the reports are offering potential profits to traders. Again, from FactSet, “Companies that have reported positive earnings surprises for Q2 2018 have seen an average price increase of +1.1% two days before the earnings release through two days after the earnings.
This percentage increase is slightly above the 5-year average price increase of +1.0% during this same window for companies reporting positive earnings surprises.”
A Strong Earnings Report From Kraft Fits the Model For This Quarter
Among the companies with better than expected results and stronger than average performance has been Kraft Heinz (Nasdaq: KHC).
The food giant’s stock jumped sharply, an above average 8.6%, after the company posted second quarter earnings that exceeded expectations.
The chart appears to be bullish with the price closing near the high, a bullish indicator for the short term, and a reversal in momentum as shown in the MACD indicator which is displayed at the bottom of the chart above.
But, The Wall Street Journal noted, “The Brazilian private-equity executives who run Kraft Heinz had started to develop a reputation as poor long-term stewards of the company’s brands—proficient at cutting costs but less so at investing to grow sales. These perceptions had driven the stock down around 30% over the past year.
The good quarterly results could help alleviate those concerns, giving potential sellers less cause for hesitation as well.
Source: The Wall Street Journal
Yet a close look at the results reveals some reasons to remain skeptical. Organic net sales, which strip out the effects of mergers and currency fluctuations, were down by 0.4% from a year earlier, the third straight quarter of declines. In the U.S. organic sales fell for the sixth straight quarter, by 1.9%.
Kraft Heinz said it expects to start seeing organic sales growth from the third quarter onward, aided by investments it is making in marketing, including in-store promotions for back-to-school staples such as Lunchables and Capri Sun.
But there is a difference between forecasting growth and actually delivering it. Products like Lunchables are in long-term decline as consumers shift to fresher and healthier options, and Kraft Heinz doesn’t have good record so far responding to that trend.
In addition, the company appeared to pare back its outlook for earnings before interest, taxes, depreciation and amortization in the second half, partly due to the marketing investments it is making. Even for Kraft Heinz, there is no such thing as a free lunch.
On a conference call with analysts, Kraft Heinz executives said their M&A philosophy hasn’t changed. They are still looking for big brands that travel well to new markets and with the potential for big cost synergies.
That would appear to open the door for a Campbell deal, but showing some real sales growth first would help seal it.”
With room for both optimism and pessimism, traders could use a strategy that benefits from additional upside while maintaining a limited risk profile.
A Trade for Short Term Bulls
As with the ownership of any stock, buying KHC 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 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 prices stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for KHC
For KHC, the August 17 options allow a trader to gain exposure to the stock.
An August 17 $65 call option can be bought for about $0.80 and the August 17 $67.50 call could be sold for about $0.20. This trade would cost $0.60 to open, or $60 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 $60.
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 KHC the maximum gain is $1.90 ($67.50 – $65 = $2.50; $2.50 – $0.60 = $1.90). This represents $190 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $60 to open this trade.
That is a potential gain of about 216% 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.