Up Trends Can Forecast Good News
It seems to go against human nature. Many of us like to see the underdog win. That’s why gamblers at horse tracks bet on the long shot and it’s why some of us pick low rated teams to win the NCAA tournament every March.
The idea also applies to the stock market. Pulling for the underdog explains why some investors buy stocks trading near 52 week lows. They argue the stocks offer value but they are arguing with the market.
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Numerous studies have demonstrated the way to obtain market beating results in the long run is to buy stocks that are market leaders. With short term strategies, of course, it is possible to profit from market leaders or laggards.
Leaders Tend to Deliver Good News
An example of a market leader is Tiffany & Co. (NYSE: TIF). The chart below shows that the stock was in an up trend prior to announcing its earnings. The stock pulled back in line with the broad market but was stronger than the broad market.
The fact that the stock was in an up trend indicates there is a high probability of a strong earnings report. That’s simply because traders are making bets on the company based on their research.
Hedge funds research stocks ahead of earnings report. They often consult with suppliers to learn what sales might look like. They have even placed individuals near stores to count the number of shoppers entering and leaving with bags.
If their research hinted at bad news, they would close their positions. Tiffany’s up trend indicates they expected good news. And, they were correct.
The company “crushed first-quarter earnings views, raised its full-year guidance and approved a $1 billion buyback.”
Analysts had been expecting earnings per share (EPS) of $0.84 according to Zacks Investment Research. The company delivered EPS of $1.14, much better than expected.
On the sales side, analysts had been looking for revenue of $961 million for the quarter, again according to Zacks. The company reported revenue of $1 billion as same store sales increased by 10%, well ahead of the expected increase of 4.6% reported by Consensus Metrix.
The company also raised its earnings guidance for the rest of the years. Management is now expecting the company to deliver EPS of $4.50 to $4.70 for the full year. This is up from previous guidance of $4.25 to $4.45 and well above the consensus analyst forecast of $4.37.
Management also increased guidance for sales and now expects net sales to increase by a high-single-digit percentage, up from a prior view for mid-single-digit percentage gain.
Traders reacted by buying shares and quickly pushed the price up with a double digit gain when the news was released.
The next chart places the market action in a long term context.
With a new high, Tiffany is most likely on track for additional gains. However, the stock’s large gain indicates risks are heightened. This requires accepting a great deal of risk if buying the stock. It also requires having significant capital to commit to the trade if the shares are bought.
Many investors will be uncomfortable with high risk and others will lack the capital to take a significant position in the high priced stock. Options strategies can address both of these concerns.
Trading the Trend
When a stock is expected to move higher or pull back slightly, traders could consider obtaining long exposure to the stock to profit. 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 is in an up trend.
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.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread 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.
A Specific Trade for TIF
For TIF, a bull put spread could be opened with the June 15 put options. This trade can be opened by selling the June 15 $115 put option for about $1.35 and buying the June 15 $110 put for about $0.45.
This trade would result in a credit of $0.90, or $90 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 ($115 – $110). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $410 ($500 – $90).
The potential gain is about 21% of the amount of capital risked. This trade will be for about three weeks and the annualized rate of return provides a significant gain.
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 also has a high probability of success.
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