Never write a covered call or sell a cash-secured put if there is an earnings announcement due prior to contract expiration. This is such an important rule in the BCI methodology. However, we all know that life is not perfect and sometimes we are thrown the proverbial “curve ball” Earnings reports come out every quarter or every three months. If a report is released on June 1st, we would expect the next one to be made public on or around September 1st. There are times when the upcoming report is announced to come out much sooner than anticipated.
Frequently, it is related to the previous report announcement coming out much later than expected and the upcoming announcement will get the reporting back on a 3-month tract. That said, what do we do if we already entered a position and then realize that a report is due out prior to expiration because of an earlier-then-expected release date? In November 2016, this happened to one of our members, Mike, with stock Thor Industries (THO), a stock on our Premium Stock report.
Why do we avoid earnings reports?
Because of the unknown nature of the report and how the “market” will react to it, there is an extreme amount of implied volatility in the stock which can move it significantly up or down in price after the announcement. By selling a covered call, we are capping the upside (resulting from a positive surprise) and leaving the downside unprotected (outside of the option premium). This is taking a conservative options strategy and transforming it into a risky one. This may be okay for some but an event to avoid for most. There are times we really like a stock and perhaps it has also had a history of positive surprises.
In these scenarios, it is better to hold the stock through the report to take advantage of share appreciation following a positive report and then sell the option…our goal is to benefit from both a positive report and from option premium. In most cases, we simply will not own the stock until the report passes.
Mike’s trade
- Buy 200 x THO at $86.62
- Sell 1 x December $85.00 call for $4.20
- Sell 1 x December $90.00 call for $2.16
- Became aware of a 2-month (from last report) earnings release on November 27th, the day prior to the after-market close report
- Stock price currently is $90.67
- Cost to close the 2 positions: $750.00 + $420.00 = $1170.00
Technical chart prior to the report
In February 2015, a negative surprise resulted in a share price decline of $5.00 (see brown fields). This chart explains the inherent risk related to earnings releases and also portrays a bullish overall chart and one of the reasons the stock earned its way onto our Premium Stock Report.
Calculations if the position is closed prior to the report
- Share profit if sold at $90.67 = 200 x $4.05 = $810.00
- Option credit = $636.00
- Total credit = $1446.00
- Cost-to-close 2 options = $1170.00
- Net credit, if closing = $276.00 (less commissions)
- 1-week return = $276.00/$17,324.00 (cost of 200 shares) = +1.6%
We can actually generate an impressive 1-week return and avoid the risk of a negative surprise. We can also just close the short calls and retain the 200 shares with a goal to benefit from a positive surprise. Here we are still incurring the earnings release risk but not capping the upside.
So what happened?
A positive earnings surprise resulted in an increase in share value of $10.00 the next trading day after the report was made public. Those who held the stock benefitted the entire amount because the call was removed and the upside was not capped. Those who closed the entire position and did not own the shares, did not profit from the share advance but did remove the risk of a potential negative surprise…we look forward not back.
Discussion
Earnings reports should be avoided. In cases when reports are scheduled to be made public in an unexpected shorter time frame, it will be to our advantage to either close the entire position or at least the short call leg of the trade. Which approach we take will be determined by our personal risk tolerance and the confidence we have in a positive surprise based on historical data.
Market tone
Global moved up after centrist Emmanuel Macron advanced to final round of the French presidential elections, edging out populist Marine Le Pen for the top spot. Macron holds a 20-point lead in the polls ahead of 7 May’s vote. Oil prices fell to $49.00 from $50 a barrel last week as fresh Libyan crude supplies hit the market. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), dropped to 10.82 from 14.7 a week ago. This week’s reports and international news of importance:
- Restrained by weak consumer demand, 2017 got off to unimpressive start in the United States, with the economy growing just 0.7%, the weakest quarter of growth in three years
- Forecasts for Q2 growth are running in the 3% to 4% range
- The European Central Bank surprised markets by maintaining a more dovish tone than many had expected. Bank president Mario Draghi allowed that downside economic risks had diminished, but he offered no hints as to whether or when the ECB will begin to dial back its asset purchases
- The Bank of Japan indicated it would maintain its present ultra-loose monetary policy amid signs of slightly stronger domestic growth but still-very-low inflation
- The Trump administration turned its attention to tax reform this week, releasing an outline of a proposal it will send to Congress. Under the plan, seven tax brackets would be reduced to three, the corporate tax would be slashed to 15% from 35% and the deductibility of state and local taxes would be ended. Notably, the proposal does not include a border adjustment tax, a centerpiece of the House GOP tax plan
- President Donald imposed levies of up to 24% on softwood lumber imports from Canada. For the past 35 years, there has been a trade dispute between the US and Canada on the commodity, which is mostly used in home building. Analysts see the imposition of tariffs as setting the tone ahead of talks on reforming the North American Free Trade Agreement
- Trump said this week that he will not withdraw from NAFTA “at this time” after media outlets reported that his administration had drafted a preliminary executive order pulling the US out of the agreement
- With 27 EU leaders gathering on Saturday, April 29th for a summit on Brexit, German chancellor Angela Merkel took a particularly hard line on the matter in a speech before the Bundestag. Merkel said that officials in London are harboring “illusions” if they expect preferential treatment during the break-up negotiations.
According to Lipper, as of April 26th, with 242 of the S&P 500 companies reporting, aggregate earnings for Q1 2017 are expected to rise 12.4% from Q1 2016. Excluding the energy sector, earnings are expected to grow 8.7%. Revenues are expected to grow 7.2% versus a year ago, 5.2% when excluding the energy sector
THE WEEK AHEAD
MONDAY, May 1st
- Personal income March
- Consumer spending March
- Core inflation March
- Markit manufacturing PMI (final) April
- ISM manufacturing index April
- Construction spending March
TUESDAY, MAY 2nd
- Motor vehicle sales April
WEDNESDAY, MAY 3rd
- ADP employment April
- ISM nonmanufacturing April
THURSDAY, MAY 4th
- Weekly jobless claims
- Trade deficit March
- Factory orders March
FRIDAY, MAY 5th
- Nonfarm payrolls April
- Unemployment rate April
- Consumer credit March
For the week, the S&P 500 moved up by 1.51% for a year-to-date return of 6.49%.
Summary
IBD: Market in confirmed uptrend
GMI: 6/6- Buy signal since market close of April 21, 2017
BCI: I am currently selling an equal number of in-the-money and out-of-the-money strikes, a neutral posture… too much geopolitical and domestic uncertainty for me to join the bullish party at this time
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a moderately bullish outlook. In the past six months, the S&P 500 was up 12% while the VIX (10.82) declined by 34%.