Rolling the Dice with Earnings

With earnings season ready to begin its second full week there are again some opportunities to identify stocks whose earnings may represent risk that is over-estimated by the options market, yet may still offer attractive premiums outside of the presumed risk area.

While in a perfect world good earnings would see increased share prices and bad earnings would result in price drops, the actual responses may be very unpredictable and as a result earnings reports are often periods of great consternation and frustration.

For the buy and hold investor, while earnings may send shares higher, this is also a time when paper profits may vanish and the cycle of share appreciation has to begin anew. Other than supplementing existing positions with strategic option positions, such as the purchase of out of the money puts, the investor must sit and await the fate of existing shares.

Occasionally, a covered option strategy, either through the sale of puts or buy/write transactions, may offer opportunity to achieve an acceptable return on investment while limiting the apparent risk of exposure to the large moves that may accompany good, bad or downright ugly news. Although a roll of the dice has definable probabilities, when it comes to stocks sometimes you want something that seems less predicated on chance and less on human emotion or herd mentality.

As always, whenever I consider whether an earnings related trade is worth pursuing I let the “implied volatility” serve as a guide in determining whether there is a satisfactory risk-reward proposition to consider action. That simple calculation provides an upper and lower price range in which price movement is anticipated and can then be compared to corresponding premiums collected for assuming risk. It is, to a degree based on herd mentality in the option market and has varying degrees of emotion already built into values. The greater the emotion, as expressed by the relative size of the premiums for strike levels outside of the range defined by the implied volatility the more interested I am in considering a position.

My preference in addressing earnings related trades is to do so through the sale of put contracts, always utilizing the weekly contract and a strike price that is below the lower range defined by the implied volatility calculation. Since I’m very satisfied with a weekly 1% ROI, I then look to find the strike level that corresponds to at least a 1% return.

While individuals can and should set their own risk-reward parameters, a weekly 1% ROI seems to be one that finds a good balance between risk and reward, as long as the associated strike level is also outside of the implied volatility range. If the strike level is within the range I don’t assess it as meeting my criteria. I sometimes may be less stringent, accepting a strike level slightly inside the lower boundary of the range if shares have already had some decline in the immediate days preceding earnings. Conversely, if shares have moved higher in advance of earnings I’m either less likely to execute the trade or much more stringent in strike level selection or expecting an ROI in excess of 1%.

While conventional wisdom is to not sell puts on positions that you wouldn’t mind owning at a specified price, I very often do not want to own the shares of the companies that I am considering. For the period of the trade, I remain completely agnostic to everything about the company other than its price and the ability to sell contracts and if necessary, purchase and then re-sell contracts repeatedly, until the position may be closed.

However, for those having limited or no experience with the sale of put contracts, you should assume a likelihood of being assigned shares and the potential downside of having a price drop well in excess of your projections. For that reason you may want to re-consider the agnostic part and be at peace with the potential of owning shares at your strike price and helping to reduce the burden through the sale of calls, where possible.

Since my further preference is to not be assigned shares, I favor those positions that have expanded weekly options available, so that there is opportunity to roll contracts over in the event that assignment appears likely using a time frame that offers a balance between return and brevity.

This week there are a number of stocks that will release quarterly earnings that may warrant consideration as the reward may be well suited to the risk taken for those with a little bit of adventurousness.

A number of the companies highlighted are volatile on a daily basis, but more so when event driven, such as with the report of earnings. While implied volatilities may occasionally appear to be high, they are frequently borne out by past history and it would be injudicious to simply believe that such implied moves are outside the realm of probability. Stocks can and do move 10, 15 or 20% on news.

The coming week presents companies that I usually already follow. Among them are Amazon (AMZN), Cliffs Natural Resources (CLF), Cree (CREE), Deckers (DECK), Facebook (FB), Gilead (GILD), Microsoft (MSFT) and Netflix (NFLX).

The table above may be used as a guide for determining which of these stocks meets personal risk-reward parameters, understanding that re-calculations must be made as share prices, their associated premiums and subsequently even strike level targets may change.

While I most often use the list of stocks on a prospective basis in anticipation of an earnings related move, sometimes the sale of puts following earnings is a favorable trade, especially in instances in which shares have reacted in a decidedly negative fashion to earnings or to guidance.

Regardless of the timing of the sale of puts, before or after earnings are released, being more pessimistic regarding the potential for price drops may be an enticing trade for the generation of income.

Weekend Update – January 19, 2014

As you get older you realize certain truths and realities and they aren’t always warm and fuzzy.

One of those realities is that often many years of marriage come to an end once the children have left the household. Without the diversion of children always in need comes the realization that there is nothing of substance to hold together a failing foundation. Sometimes the realization is there, but swept under the rug as other events take precedence, but you always know that someday reality can no longer be delayed.

With my youngest child having graduated college that appears to be the story that we’ve heard on multiple occasions from like aged acquaintances and friends. Like most everything else in life there are parallels to the stock market.

We now find ourselves in a market faced with certain realities but without the diversions offered by European monetary crises, sequestration, fiscal cliffs, government shutdowns, quantitative easing, credit downgrades and budgetary deadlines. Those diversions conveniently removed focus from the very foundation upon which stocks find their fair price and to which markets have traditionally responded.

All that is now left behind is earnings and it’s not a pretty prospect.

Perhaps in a manner similar to those in long standing unions who suddenly suffer from improved judgment following a youth blinded by the superficial, the market went through a period of not being terribly discerning and always finding reason to go higher. Interpreting economic news to be something other than what it is has its counterpart in idealizing the idea more than the hard facts.

The reality that is being faced is that of earnings and the failing of earnings to support an ongoing rise in the stock market.

Early suggestions that this earnings season would result in a 6% increase could only be the result of optics as publicly held shares have diminished through massive stock buybacks. However, it doesn’t take much insight to realize that the abysmal state of retail earnings has to have some meaning with regard to the ability of individuals to find discretionary spending within their reality.

As with the past two quarters with the big money financial centers reporting positive earnings, there is little reason to believe that will extend to the other members of the S&P 500 as they begin their reporting in earnest this week.

I’m prepared for the reality, but I still like the fantasy, so I expect to continue playing along this week, just a little more mindful of the obstacles that have a lot of catching up to do.

As usual, the week’s potential stock selections are classified as being in Traditional, Double Dip Dividend, Momentum and “PEE” categories this week (see details).

Among those reporting earnings this week is Coach (COH) which had fallen 6.2% last week, in preparation for what has become a near regular occurrence in the past 18 months upon earnings. While its most recent past has been to shed significant value when all is bared the option market is expecting an implied move of nearly 10%, in addition to the recent weakness. While Coach has had its competitive challenges it has somehow been able to find a fairly well defined trading range, punctuated with some significant moves and periods of recovery or occasionally, decline. In 2013, I traded Coach for all earnings reports, three of which were through the sale of puts. Despite the dramatic moves following all of last year’s earnings reports, predominantly lower, Coach has been and may continue to be an erratic position that offers acceptable reward for defined risk.

Cypress Semiconductor (CY) also reports earnings this week. Just a few months ago, prior to its last report, it did what many have been doing of late and offered some earnings warnings and saw shares plummet more than 20%, leaving virtually nothing more to fall. Like Coach, Cypress Semiconductor has a habit of seeing its share price gravitate back toward a set level with some regularity. Having already fallen approximately 4% in the past two weeks. While the option market is implying a 9% move this week as earnings are announced, I think that it will be much less pronounced and more likely to have some upside potential. After having shares assigned this past Friday, rather than selling puts,as I often do when earnings are at hand, I am considering the purchase of shares and sale of calls on only a portion of shares or at both the $10 and $11 levels to potentially capitalize on share appreciation.

Anadarko (APC) had a brief spike in price this past week, nearly three weeks after plummeting upon news that it might be facing a $14 billion judgment in a case involving a company that it had purchased several years ago. The spike came as Anadarko stated that it believed the judge in the case set damages that were punitive, rather than remedial and believed that the appropriate amount was more in the $2 billion range. It will likely take a long time to come to some resolution, but even at $14 billion there is certainty and the ability to move forward. As shares seem to be creating a new base I think this is a good entry point, as well as a good point to add shares to start the process of offsetting the paper losses from older shares.

Chesapeake Energy (CHK), while trading in a range of late, has also been trading with relatively large daily and intra-day moves. As a result shares enjoy generous option premiums that reflect the volatility, despite having traded in a very stable range for the past 5 months. Offering expanded weekly options I would consider selecting an expiration prior to the scheduled February 20, 2014 earnings report date.

Having already announced earnings Unitedhealth Group (UNH) added to its recent losses and is now down approximately 5% since its recent high. It appears to have some price support a dollar lower than its current price, which may be a good thing considering the unknowns that await as more news trickles in regarding registration demographics and utilization among newly enrolled health care policy holders. While I never move into a position with the idea that it will be a long term holding, I don’t hold too much concern for that unwanted possibility as it’s as likely to recover from any price drops as most anything else and could easily be justified as being a core holding.

The potential dividend choices this week share a “household theme” covering aspects of the kitchen, laundry room and bathroom, but represent different ends of the consumer spectrum when defensive investing is foremost.

While Clorox (CLX) and Colgate Palmolive (CL) may be best known for consumer staples and nothing terribly ostentatious, Williams Sonoma (WSM) offers products that are every bit as critical to some. Those who would sacrifice anything to ensure that they can purchase an oversized block of Mediterranean pink salt have money every bit as valuable as those that like bright white shirt collars and bright white teeth.

More importantly, at least for me, they have all recently under-performed the S&P 500 and all trade with a low beta at a time that I want to balance risk and still generate a reasonable income stream from premiums and dividends. While both Clorox and Colgate Palmolive have earnings reports due in the February option cycle, WIlliams Sonoma, which tends to trade with more volatility upon earnings, does not report until the end of the March 2014 cycle.

Finally, for those who really seek reckless adventure, perhaps only frolicking in a landfill brimming with its products offers more excitement than considering shares of LED light bulb maker Cree (CREE) in advance of earnings. The last time I considered an earnings related trade in Cree I didn’t recommend the purchase or sale of puts to my subscribers, but did make the put sale for my personal account. However, I did so only after earnings, believing that the 16% drop offered sufficient protection to make an out of the money put sale with relative impunity.

Like some other stocks this past week that continued to fall even days after earnings plunges, that’s what Cree did. Rolling over the puts on a few occasions, eventually taking assignment and then selling calls until its final assignment at a strike level 5% higher than the original put strike price made it worthwhile, but more thrilling than necessary.

So unnecessary that I may be ready to do so again.

Traditional Stocks: Anadarko, Unitedhealth Group

Momentum Stocks: Chesapeake Energy

Double Dip Dividend: Colgate Palmolive (ex div 1/22), Clorox (ex-div 1/27), Williams Sonoma (ex-div 1/22)

Premiums Enhanced by Earnings: Cree (1/21 PM), Coach (1/22 AM), Cypress Semiconductor (1/22 AM)

Remember, these are just guidelines for the coming week. The above selections may become actionable, most often coupling a share purchase with call option sales or the sale of covered put contracts, in adjustment to and consideration of market movements. The overriding objective is to create a healthy income stream for the week with reduction of trading risk.

Weekend Update – October 20, 2013

With the S&P 500 having reached an all time high this past week you could certainly draw the conclusion that a government shutdown is a good thing and flirting with default is a constructive strategy. At a reported cost of only $24 Billion associated with closure and nothing more than a symbolic “Fitch slap” credit watch issued, perhaps we should look forward to the next potential round in just a few months.

For me, this past week marked the slowest week of opening new positions that I can recall since the 2009 market bottom. Although history suggests that the eleventh hour is a charm, the zeal of some more newly elected officials was reminiscent of a theological premise that believes in order to save it you must first destroy the world. That kind of uncertainty is the kind in which you get your affairs in order rather than embarking on lots of new and exciting initiatives.

With manufactured uncertainty temporarily removed the market can focus on earnings and other things that most of us believe are somewhat important.

One thing that will be certain is that wherever possible the next earnings season will attempt to lay some blame for any disappointments upon the government shutdown. This past week it certainly didn’t take Stanley Black and Decker (SWK) and eBay (EBAY) very long to already take advantage of that excuse. Who knew that government purchasing agents were unable to use eBay for Blackhawk helicopter replacement parts during their unexpected furlough?

As with the previous earnings season the financial sector started off the reports in a promising way, although early in the season the results are mixed, with some significant surges and plunges. What is clear is that investors are paying particular attention to guidance.

One earnings report that caught my attention was from Pet Smart (PETM). My father always believed that no matter what the economic environment, people would always find the wherewithal to spend on the pets and their kids. Pet Smart’s disappointing earnings focused on a “challenged consumer” and lower customer traffic. That can’t be a good sign. If pets are going wanting what does that portend for the rest of us?

Yet, on the other hand, Align Technology (ALGN) discussed last week, was a different story. Certainly representing discretionary spending and not benefiting from any provisions in the Affordable Care Act, their orthodontic appliances see no barriers from the economy ahead, as they reported great earnings and guidance.

Also clouding the picture, perhaps both literally and figuratively, is the positive guidance provided by Peabody Energy (BTU). For a nation that has been said to “move on coal,” that has to be a signal of something positive going forward.

This week, with lots of cash from assignments of October 2013 option contracts, I’m anxious to get back to business as usual, but still have a bit of wariness. However, despite the appearances of a reluctant consumer, I’m encouraged by recent activity in the speculative portion of my portfoli0, enough so to consider adding to those positions, even at market highs.

As usual, the week’s potential stock selections are classified as being in Traditional, Double Dip Dividend, Momentum and “PEE” categories this week (see details).

The news from Peabody Energy in addition to some recent price stabilization in Walter Energy (WLT), Cliffs Natural Resources (CLF) and Freeport McMoRan (FCX) have me in a hopeful mood after long having suffered with positions in all three.

A year ago at this time I believed that Freeport McMoRan would be among the best performers in 2013, but subsequent to that it has only recently started on its recovery from the price plunge it sustained when announcing plans to acquire Plains Exploration and Production, as it planned to expand its asset base to include oil and natural gas. While the long term vision may be someday vindicated, 2013 has not been a stellar year. But, like some others this week, there has been a steady strengthening in its price, despite significantly lower gold, oil and copper prices, year to date. While its dividend has made holding shares marginally tolerable through the year, I think it is now ready to start a sustained climb and it offers appealing call premiums to create income or provide downside protection. Earnings are reported this week, but the option market is not expecting a very large move.

Another company slowly climbing higher, but still with a great distance to travel is Walter Energy . In addition to suffering through a proxy fight this year and significant challenges to management, declining coal prices and a slashed dividend, I believe that it is also poised to continue climb higher. I recently tested the waters and added shares along with selling in the money calls. Those were just assigned, but I think that I’m ready to dip deeper.

Sticking to the same theme, Cliffs Natural Resources goes hand in hand with Walter Energy, at least in its price behavior and disappointments. It too has slashed its dividend and its CEO has retired. Like Walter Energy, I recently started adding shares and had them assigned this week. Cliffs reports earnings this week and unlike Freeport McMoRan, the option market is expecting a larger price move.

While I rarely do more than glance at charts, in the case of Cliffs Natural Resources the 5 Year price chart may suggest a long term pattern that has shares at the beginning of a sustained climb higher.

As with many positions that are preparing to report earnings, I typically consider potential entry through the sale of put options.

Also reporting earnings this week is Cree (CREE). Thanks to legislation its LED light bulbs have become ubiquitous in home improvement stores and homes. It has the features of companies that make potentially alluring earnings trades. In this case, this always volatile moving company can sustain up to a 14% price decline and still return a 1% ROI for the week. The only real consideration is that it is capable of making that decline a reality, so if selling puts you do have to be prepared to take ownership.

While already having reported earnings and falling into the “disappointing” category, Fastenal (FAST), which I look at as being an economic barometer kind of company has already started regaining its price decline. It will be ex-dividend this week offering an additional reason to consider its purchase, even though I already own lower priced shares and rarely buy additional lots at higher prices. However, with W.W. Grainger (GWW) recently reporting positive earnings I’m encouraged that Fastenal will follow, but in the meantime the dividend and option premium make it easier to wait.

Also going ex-dividend this week is Williams-Sonoma (WSM). I considered its purchase last week, but it fell victim to a week of my inaction. While perhaps at risk to suffer from decreased spending at some higher end stores it has already fallen about 11% from its recent high point. However, since it reports earnings just prior to the expiration of the November 2013 option cycle, I might consider utilizing a December 2013 covered call sale.

The Gap (GPS) isn’t at risk of losing too many high end customers, it has just been losing customers, at least on the basis of its most recent monthly report. It is one of those retailers that still reports monthly comparison figures. That’s just one more bullet that needs to be dodged in addition to potential surprises during earnings season. Shares went precipitously lower with its most recent retail report and caught me along with it. It is near a price support level and represents an opportunity to either purchase additional shares to attempt to offset paper losses of an earlier lot or to establish an initial covered position.

While eBay may not sell used Blackhawk helicopter parts it somehow found a way to link its coming fortunes to the government shutdown. Suffering a significant price drop following earnings and guidance shares were once again in a channel of great familiarity. Having traded reliably in the $50-$52.50 range the sight of it falling was well received. However, late in the trading session on Friday someone else must have seen the same appeal as shares suddenly jumped $1.65 in about 20 minutes. That takes away some of the appeal. What takes away more of the appeal was the explanation by CEO Donahoe that spurred the surge, when he explained that he and his CFO did not mean to sound so dour about holiday prospects, it’s just that they both had colds.

On the other hand UnitedHealth Group (UNH) is a company that may be able to justifiably point its finger at the Federal government when it reports earnings again in January 2014. Already suffering a nearly 10% drop in the past week related to 2014 guidance, UnitedHealth is a major player in the options available on the Affordable Health Care Act exchanges. While perhaps not being able to blame the shutdown for any revenue related woes, disappointing enrollment statistics may be in the making. The additional price drop on Friday, following the large drop on Thursday may be related to enrollment challenges rather than projections of lower Medicare funding in the coming year. However, nearing a price support and following such a large price drop provides a combination that makes ownership appealing. Perhaps eBay employees should consider signing up en masse in the event they are all prone to colds that effect their ability to perform. In enough numbers that may be helpful to UnitedHealth Group’s 2014 revenues.

Of course, while the market seemed to rejoice at what could only be construed as the return to health of the eBay executives, Groupon (GRPN) is another example of a stock whose price has returned to more lofty levels following surgical removal of its CEO. It is one of a handful of stocks that I sold last year taking a capital loss and swore that I would never buy again. Now down about 15% from its recent high, which itself was up approximately 500% from its not too distant low, Groupon is a different company in leadership, product and prospects. While still a risky position

Finally, a name that everyone seems to disparage these days is Coach (COH). While there is certainly sufficient reason to believe that retailers, even the higher end retailers are being challenged, Coach is beginning to be perceived as taking a back seat to retailer Michael Kors (KORS). SHares have certainly been volatile, especially at earnings and Coach reports earnings this week. Having owned shares a number of times in the past year, my preference is to sell puts in advance of earnings in anticipation of a large drop. Currently, the option market is implying nearly a 9% move. A 1% ROI for the week can be obtained through such a sale if the price drop is less than 12%.

Traditional Stocks: eBay, The Gap, United Health Group

Momentum Stocks: Groupon, Walter Energy

Double Dip Dividend: Fastenal (ex-div 10/23), Williams Sonoma (ex-div 10/23)

Premiums Enhanced by Earnings: Coach (10/22 AM), Freeport McMoRan (10/22), Cree (10/22 PM), Cliffs Natural Resources (10/24 PM)

Remember, these are just guidelines for the coming week. The above selections may become actionable, most often coupling a share purchase with call option sales or the sale of covered put contracts, in adjustment to and consideration of market movements. The overriding objective is to create a healthy income stream for the week with reduction of trading risk.