Trading a Better Than Expected Earnings Report
Earnings season is underway and with that comes daily news of companies beating or missing expectations. These market reactions are, in many ways predictable and rational.
Earnings announcements are usually scheduled. This gives traders a chance to prepare for the report. They can develop trading strategies to benefit from the news.
The earnings announcement provides new information about the company to the market. This news is used to update analysts’ models about the company’s future prospects. The model provides a price target and the earnings report creates an instantaneous reason to change the price target.
Given the importance of earnings and price targets, the fact that a stock makes a big move is a rational reaction to the news.
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An Unexpectedly Strong Report
W.W. Grainger Inc. (NYSE: GWW) delivered a better than expected report this week and the stock moved up by more than 12% on the news. The price action can be seen in the chart below.
This market action shows the importance of analysts’ expectations. The report itself was unspectacular.
Sales for the quarter were up 2% to $2.64 billion. Net income fell 13% to $162 million, and earnings per share (EPS) dropped 9% to $2.79.
However, the numbers did beat analysts’ expectations. Sales had been forecast to come in at $2.63 billion. EPS were expected to be $2.57 per share in earnings.
Management guidance was also mixed.
The company actually lowered 2017 guidance. It now expects 2017 sales growth of 1.5 to 2.5%, down from its previous projected range of 1-4%. EPS are now expected to be between $10.40 and $10.90, down from the prior guidance range of $10.00 to $11.30.
However, the midpoint of the earnings guidance remains unchanged at $10.65. This is slightly above analysts’ consensus estimate of $10.37.
The Question for Traders
After the large gain in the stock, traders need to assess whether the stock is likely to continue higher, remain in a relatively narrow range or slide lower, giving back much of the gain. To develop an opinion on this question, a more detailed analysis is needed.
From a fundamental perspective, the stock can be considered to be close to its fair value. On average, the stock has traded with a price-to-earnings (P/E) ratio of 19.8 for the past seven years. Using this year’s expected EPS of $10.65, the price target is $210, within a few percent of the current price.
From a technical perspective, it can be argued that there is still more potential up side in the stock. This is based on the weekly chart shown below.
In this chart, the rectangle highlights trading ranges which have developed in the stock over the past few years. After the recent surge in price, the stock is now at the lower end of the range.
This area on the chart is likely to prove to be resistance in the near term. Resistance is an area where sellers are expected to be active in the market. They could be investors who bought several years ago and are now anxious to sell near a price that allows them to get out near a break even level.
The idea of resistance has been documented in the field of behavioral economics. This is an area of economics that has been recognized with several Nobel Prizes, including the most recent one to Dr. Richard Thaler.
In the field, the disposition effect has been extensively researched. Researchers noted that “people dislike incurring losses much more than they enjoy making gains, and people are willing to gamble in the domain of losses.”
This means that “investors will hold onto stocks that have lost value…and will be eager to sell stocks that have risen in value.” The researchers coined the term “disposition effect” to describe this tendency of holding on to losing stocks too long and to sell off well-performing stocks too readily.
The professor who first wrote about the disposition effect said that investors have a “predisposition toward get-evenitis.” They will hold stocks until they get even and this is seen as resistance on price charts.
In the case of W.W. Grainger, resistance driven by the disposition effect is likely to limit the up side in the stock. Likewise, fundamentals are likely to limit the up side since the stock is trading near its fair value.
However, fundamentals also offer support because there is no reason for the stock to decline significantly since it is near fair value. There is also no known catalyst in the next several weeks to push the stock significantly up or down.
Taken together, all of these facts point to the likelihood of a trading range in the stock over the next few weeks as traders await new information about the company and selling pressure limits the up side.
A Strategy to Trade the News
This means the stock has rallied on the recent news and in the short term is likely to maintain its gains. Although a significant move is unlikely, it is possible to generate income from the stock. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread that could be used. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which recently saw increased volatility and is likely to remain in a narrow range.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Although it is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
For W.W. Grainger, a bull put spread could be opened with the November 17 put options. This trade can be opened by selling the November 17 $175 put option for about $1.00 and buying the November 17 $170 put for about $0.70.
This trade would result in a credit of $0.30, or $30 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $5 ($175 – $170). This is multiplied by 100 since each contract covers 100 shares.
In dollar terms, the total risk on the trade is then $470 ($500 – $30).
The potential gain is about 6.4% of the amount of capital risked. This trade will be open for about one month and the annualized rate of return provides a significant gain.
Options pricing models indicate there is a 93% probability of a profit on this trade. This could make the trade appealing to risk averse investors.
The bull put spread is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy could also simplify tax reporting for investors.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.