Triple Digit Income Potential From An Earnings Report
Trade summary: A bear call spread in Vulcan Materials Company (NYSE: VMC), using March 20 $135 call options for about $6.70 and buy a March 20 $140 call for about $3.70. This trade generates a credit of $3.00, which is the difference in the amount of premium for the call that is sold and the call.
In this trade, the maximum risk is about $200. 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 ($300).
This trade offers a potential return of about 150% of the amount risked.
Now, let’s look at the details.
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This income is potentially available because Vulcan Materials Company (NYSE: VMC) failed to meet analysts’ expectations in their latest earnings report. The stock was already at resistance when the news came and the combination of news and a weak chart sets up the trade.
Zacks reported that Vulcan reported “adjusted earnings of $1.08 per share, lagging the consensus mark of $1.12 by 3.6%. However, the company’s bottom line improved 9.1% from the year-ago level.
Earnings and revenues improved on a year-over-year basis, given solid shipment growth and strong pricing in the aggregates business. Also, robust growth in public construction demand and continued improvement in private demand added to the positives.
But overhead expenses increased more than sales.
For the full year, adjusted earnings came in at $4.70 per share, up 16% from the 2018 level. The company told analysts to expect continued growth this year.
Management, according to Zacks, “expects double digit earnings growth in 2020. Its earnings from continuing operations for the full year are expected within $5.20-$5.80.”
At the midpoint of expectations, the stock is priced at about 26 times earnings. This is a richly priced stock in a market that appears vulnerable. The rich valuation could explain why the stock has failed to reach its 2019 highs. That can be seen in the chart below which uses weekly price data.
The stock stalled in 2019 after a strong rally and there appears to be little upside potential. To benefit from weakness, traders could sell the stock short but that strategy carries a large amount of risk and is not suitable for all investors.
Buying put options is another strategy that could be used to benefit from weakness. That can be expensive.
A spread trade with options allows traders to obtain exposure to the stock with a defined level of risk. That strategy is explained in detail below, at the end of this article.
A Specific Trade for VMC
For VMC, we could sell a March 20 $135 call for about $6.70 and buy a March 20 $140 call for about $3.70. This trade generates a credit of $3, 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 $300 The credit received when the trade is opened, $300 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $200. 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 ($300).
This trade offers a potential return of about 150% 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 VMC 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 $300 for this trade in VMC.
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.