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Beware of Earnings Unless You Dare

Although the first week of this most recent earnings season has been less than spectacular, as the financial sector has suffered under a low interest rate environment, I continue to look at the more speculative portion of my portfolio as being available to generate quick income from stocks before or after earnings are announced.

During a week that stocks, interest rates, oil, precious metals and currencies have all gyrated wildly, what’s a little added speculation with earnings?

The process of trading in anticipation or after earnings news is one that seeks to balance risk with reward, accepting a relatively small reward in exchange for taking on a level of risk that appears to be less than the market is expecting.

The basic concepts and considerations in the approach are related to:

  • personal ROI goal;
  • individual temperament for risk, and
  • time and ability to trade in or out of risk in response to events.

The concepts are covered in previous articles, but in summary, the objective is to find a stock that can deliver an acceptable ROI when selling a weekly put option at a strike level that is lower than the bottom of the range defined by the option market’s implied volatility for that stock.

For my tolerances I seek a 1% ROI for a weekly position at a strike price that is outside the boundaries implied by the option market.

While achieving the desired ROI is an objective metric, and should be done within the context of acceptable risk, the decision process to initiate a trade is frequently based upon share behavior.

My preference, when it appears that both the risk and the reward measures are satisfactory, is to sell puts into share weakness in advance of earnings. If that condition isn’t met, I may also consider the sale of puts after earnings if there is significant price weakness after the report.

After Friday’s strong close, which may have come as a surprise to most everyone after a week of declines, many stocks reporting earnings next week may now be coming off of Friday’s advances. Insofar as Friday’s performance may have represented a reflexive bounce higher, I would be initially reluctant to jump into any put sale related trades for concern about an equally reflexive drop lower.

However, a number of the positions covered in this article have already suffered large losses in advance of their earnings report, some perhaps due to altered guidance and many are already well off from their highs, even as the S&P 500 is barely 4% lower after a quick triple bottom.

I tend to be more interested in those stocks that have already fallen than I am in those whose shares are moving higher prior to earnings, as that moves the strike level that I would have to use to achieve my desired 1% ROI for the week higher, and may also shift premium enhancement on the call side of the equation, rather than to the put side, which also contributes to a lower ROI.

While the traditional opinion and belief is that put sellers must be willing to own the shares in which they have sold puts, I often do not want to take ownership unless an ex-dividend date is approaching. While many sell puts in order to gain an entry into share ownership at a lower and more attractive price, I do so generally in order to capture the income stream from the option sales.

For that reason, it is important to have liquidity in the options market in order to be able to concurrently close the position and open a new one for a forward week if assignment is unwanted. Ideally, that would also be done at a lower strike price, however, in an otherwise low volatility environment, as we currently have, despite some recent increase, that is a difficult objective unless there is additional stock specific volatility, as may be seen in the energy sector currently.

Whether able to rollover to a lower strike level or not, the primary goals are to delay or prevent assignment and to collect additional net premiums in an attempt to ultimately see the position expire or be closed.

Among the stocks for consideration this week are many that can be readily recognized for inherent risk, which may also influence price behavior on a regular basis regardless of upcoming earnings or guidance.

This week I’m considering the sale of puts of shares of Cree (NASDAQ:CREE), Freeport McMoRan (NYSE:FCX), F5 Networks (NASDAQ:FFIV), General Electric (NYSE:GE), International Business Machines (NYSE:IBM), Intuitive Surgical (NASDAQ:ISRG), Netflix
(NASDAQ:NFLX), Starbucks (NASDAQ:SBUX), SanDisk (NASDAQ:SNDK) and United Continental Holdings (NYSE:UAL).

 

 

Generally I don’t spend too much time considering the relative merits of the stocks being considered for earnings related trades, preferring to remain agnostic to those issues and simply following guidelines outlined above.

Looking at this week’s list, there is no shortage of stories in advance to scheduled earnings, such as SanDisk releasing altered guidance or Freeport McMoRan feeling the sudden weight of collapsing copper prices, in addition to its growing exposure to gold and energy prices.

While I don’t use margin to add stock positions, it is often perfectly suited for this kind of trading activity. I generally use these trades in an account hat has margin privileges. While selling cash secured puts decreases the amount of margin that is available to you, it does not draw on margin funds and, therefore, doesn’t incur interest expenses. Those expenses will only be incurred if the shares are assigned to you and are subsequently purchased through the use of the credit extended.

One thing noticed among the positions cited above is that fewer are meeting my criteria and being assigned a “YES” designation. That may reflect an increasing sense of pessimism among option market traders as compared to previous quarterly earnings periods. Normally I would only consider those with a “YES” rating, but may now also consider those that are “MARGINAL.”

If considering the sale of put options, there is always a possibility of early assignment, especially if shares go far below the strike price and when using a weekly contract. If that occurs, the seller of the put contracts should be prepared to either own shares or attempt to rollover the put option to a forward date.

The lower the volatility environment the less benefit there is to the put holder to delay assignment for deep in the money positions. In the event of early assignment the opportunity is then created to begin managing shares and enhancing return through the sale of call options. However, where possible, it may be best to consider pre-emptive action in order to prevent or delay assignment.

Finally, in the current market environment, moves, especially downward, seem to be sudden and magnified. If pursuing any of these earnings related trades it helps to have exit strategies planned in advance and to limit falling prey to surprise, as that may be the one thing that can be counted upon.

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Weekend Update – April 7, 2013

I’m was beginning to feel like one of those Pacific Island soldiers that never found out World War II had ended and remained ever-presently vigilant for an impending attack that never came.

Amazingly, some held up their vow to defend for decades while I’m having difficulty after a bit more than a month waiting for a correction. Nothing big, just in line with this same time period in 2012, as I see lots of similarities to that time, not only in the parallel nature of the charts, but also in my own less than stellar performances, having been selling covered options as religiously as a sentinel keeps an eye on the horizon.

Having weathered the acute shock value of Cyprus, decreasing economic growth in China, currency manipulation in Japan and digested the initial uncertainty of the Korean Peninsula, it looked as if any sentinel for a sell-off would be a lonely soldier.

Now faced with a disappointing employment situation there’s opportunity to wonder over the weekend whether the pole has been sufficiently greased or whether this is simply the very quick mini sell-off of April 2012 that occurred just as Apple (AAPL) hit its high, then quickly recovered, just in time to lead to a 9% sell-off.

Apple had came off its April high by 5% at that point that the greater market downturn began, which is that same point that Google (GOOG) was down from its recent high point, at the close of Thursday’s trading (April 4, 2013). Coincidentally, that was the day before today’s sell-off. For those that have believed that Google has rotated into market leadership, having wrestled the position away from Apple, that may be a cause for concern. as does the fact that Google has traded below that dreaded 50 Day Moving Average.

I don’t know much about those kind of technical factors, but I do recognize that sometimes there is a basis for deja vu being more than just a feeling. What actually exists over the horizon is still anyone’s guess, but unlike those lonely soldiers you can feel relatively assured that at some point an unwelcome visitor will appear and wreak some havoc on the market. From my perspective that comes along every 52 months, so I’m not quite ready to accept that the time has come to drop defenses, but there may be room to let the guard down a bit.

As usual, the week’s potential stock selections are classified as being in Traditional, Double Dip Dividend, Momentum and “PEE” categories, as earnings season begins anew on April 8, 2013 (see details). Additionally, for the first time in a few weeks there is a somewhat greater emphasis on Momentum stocks, as a coming downslide might reasonably be expected to unduly impact upon issues that have thrived recently, particularly the more defensive stocks. However, I am still inclined to consider monthly contracts over weekly ones, simply for a little extra breathing room while continuing to await a market heading in a southerly direction.

One Momentum stock that has also thrived up until very recently is YUM Brands (YUM). It also happens to go ex-dividend this week and has already given back much of its gains in the absence of any news. In the past it has demonstrated itself very capable of bouncing back from both real news and speculation regarding its forward prospects. Simultaneously being held hostage to the Chinese economy and also proving to be independent of swirling winds, YUM Brands serves as a model of what can be achieved in a marketplace where the playing field is anything but level.

A real signal that something is evolving, at least from my perspective, is that I no longer classify AIG (AIG) as a Momentum stock. Over the past year, had I followed by frequent suggestions that AIG might be an appropriate covered call position, I think I could have limited my portfolio to a single stock. Robert Ben Mosche, it’s CEO is the poster child for leadership and focus. With some recent share weakness, I think it may be time to add it back to a portfolio in need of income and reasonable price stability.

A couple of months ago I made an earnings related trade in F5 Networks (FFIV) that worked out nicely. Having sold puts just prior to earnings, F5 surpassed expectations and the trade was closed in 4 days. Thursday evening after the closing bell, F5 release disappointing guidance that saw its shares fall more than 15%.

I hate guidance that comes out weeks before earnings and catches me off-guard. In the past I’ve seen Cummins Engine (CMI) and Abercrombie and Fitch (ANF) seem t
o regularly upset happy shareholders with that kind of timed guidance. Despite the fact that analysts seem to be in agreement that this is solely an F5 issue, it indiscriminately drags down the sector, perhaps offering opportunities.

In this case, I think the opportunities are now in both Cisco (CSCO) and Riverbed Technology (RVBD), both unduly hit in the aftermath of F5 and just a couple of weeks ago by Oracle’s (ORCL) disappointing earnings, which were also agreed to be an Oracle specific shortcoming. I currently own shares of Riverbed and would even consider adding to the position ahead of earnings later in the month.

Western Refining (WNR) returns to the list from last week, as an unrequited purchase. It is, possibly another example of how the market acts indiscriminately and emotionally. Following Valero’s (VLO) moaning about the costs of upcoming EPA initiatives for cleaner gas the market punished the entire sector, despite the fact that the EPA suggested that the costs of compliance were minimal for most refiners. The market made no distinction and assumed that all refiners would be subject to additional costs similar to the $300-400 million suggested by Valero. Unfortunately, I didn’t have the fortitude to pick up shares of Western Refining as it briefly dipped below $30 or Phillips 66 (PSX) as it fell about 10%. It didn’t stay there very long and certainly never confirmed the worst case scenario that Valero so openly shouted.

MetLife (MET) also returns from last week, which was another week of hesitancy to commit cash in favor of building reserves. There were, however, a number of times that I was ready to part with some of the cash, but ultimately resisted. As opposed to Western Refining, MetLife’s shares went down even further, so those decisions to embrace inaction may have balanced one another out. I continue to believe that shares will benefit from an increasingly healthy housing market, although that is far from MetLife’s core and highest profile business.

The financial sector was hit quite hard this past week. Since I owned shares of both Morgan Stanley (MS) and JP Morgan (JPM), I was acutely aware of their duress. However, in addition to JP Morgan and Wells Fargo (WFC) releasing earnings this Friday and perhaps representing some opportunity, Bank of America (BAC), whose shares I had assigned just a week ago has given up much of its recent run-up higher and is becoming attractive again.

Finally, Bed Bath and Beyond (BBBY) s one of my favorite stores, but not one of my favorite stocks. It has had a bit of a price rise on some buy-out speculation and it has demonstrated past ability to disappoint on earnings. Already down about 4% from its very recent high, I would be comfortable owning shares at $60 and would consider a 1.5% ROI for a 2 week holding period to be a decent reward while anticipating less than a 5% decline in share price in the after-math of earnings.

Traditional Stocks: AIG, Cisco, MetLife

Momentum Stocks: Bank of America, Riverbed Technology, Western Refining,

Double Dip Dividend: YUM Brands (ex-div 4/10)

Premiums Enhanced by Earnings: JP Morgan (4/12 AM), Pier 1 (4/11 AM), Wells Fargo (4/12 AM)

Remember, these are just guidelines for the coming week. Some of the above selections may be sent to Option to Profit subscribers as actionable Trading Alerts, most often coupling a share purchase with call option sales or the sale of covered put contracts. Alerts are sent in adjustment to and consideration of market movements, in an attempt to create a healthy income stream for the week with reduction of trading risk.

Some of the stocks mentioned in this article may be viewed for their past performance utilizing the Option to Profit strategy.

 

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Weekend Update – January 27, 2013

By Thursday evening I had already lost track of how many records and new highs had been set as trading was getting ready to enter the final week of January. Depending on the parameters and definitions it seems as if every minute someone was referring to one new market high of one sort or another.

Sometimes I think that the Wilshire 5000 doesn’t get its due recognition, but if the trend continues it will join the party, even if only to have set a record for intra-day trading level on a Tuesday following inauguration.

If they weren’t calling new records they were hyper-focused on just how far we were from a new record. By the way, just for the record, the WIlshire 5000 is 1.3% away from its all time record high.

After a while the meaning of a record becomes less and less. I certainly didn’t feel the special nature of whatever was being watched so closely. S&P 500 at 1500? For me, the only record that counts is 14,164 for the Dow and 1565 on the S&P 500, both more than 5 years ago.

But even those records are meaningless, because all that really matters is where your own assets are residing.

I’d also lost track of how many consecutive gaining days we had other than to remember that last January seemed to be the very same. Like through a million cuts we went higher each and every day, simply setting a record for the number of slices.

You don’t have to be a short seller to bemoan a relentless upward path, but it’s a little more excruciating when there’s no apparent reason for what has caused such despair. At least Ackman knows where Loeb lies.

Alright, it hasn’t really been excruciating and it hasn’t really been a period of despair to live and die by covered option sales. That may be a bit of an exaggeration, as you do share in the market’s gains, but maybe not as much. Of course, that assumes that the next guy is actually taking their profits rather than falling prey to human nature and letting it all ride. I like taking profits on a very regular basis and moving on before the welcome is outstayed.

Records don’t mean very much. Just ask the performance enhanced athletes that are being denied recognition for their accomplishments. I don’t really know what exactly is juicing the markets right now, but I do know that there’s little reason to believe that the recent heights are deserved.

Ultimately, looking back at the record highs of October 2007, I realize that the best performance enhancer since then has been ignoring the occasional mindless melt ups and doing the conservative thing. Collecting penny by penny selling those options until the sum of the parts is greater than the whole. I continually maintain that you don’t have to be a great stock picker or market timer to have your records beat theirs.

And get there sooner.

As volatility keeps setting its own record lows it does become more challenging to get more pennies for your efforts in selling options. Although I’ve never been much of a fan of earnings season, at the very least it does its part to enhance premiums, if you don’t mind the enhanced risk, as well. As a covered call seller risk is not high on the list of favorite things, but there has no be some solace in knowing that a uni-directional move sooner or later has to come to an end. Hopefully, when it does, it won’t be quite as bruising as has been the descent of Apple (AAPL) after its one way journey higher.

As always, the week’s selections are categorized as either being Traditional, Momentum, Double Dip Dividend, or “PEE” (see details).

What strikes me this week is how I had a very difficult time identifying a “Traditional” candidate. Over the past month the least well performing sector, Utilities, has nonetheless delivered growth. The makes it difficult to spot potential targets that are also fairly priced.

That brings me to the elephant in the room. For the second week in a row Apple is back on the list. Last week it was a possible earnings related trade. Up until an hour before the close of Wednesday’s trading I thought of selling weekly $480 puts, but decided that having done the same with Mellanox (MLNX) and F5 Networks (FFIV) enough was enough. What exactly does that say when either Mellanox or F5 Networks is thought to be less risky than Apple? It probably says something about my delusional diagnostic methodology rather than the respective companies. But as Apple is now near the last price at which I owned it and closer to a $425 support level, it just seems harder to ignore. I think that once Tim Cook replaces the “WWJD” bracelet on his wrist and gets a new one from which to draw inspiration and guidance, things will get back to normal. The new bracelet would simply be inscribed “WWJD.” The difference? What Would Jobs Do?

With the “Traditional” category so quickly dispatched, it’s another week and another reason to think about adding shares of AIG (AIG). Of course, I wouldn’t have to consider doing that if my one and two week old lots hadn’t been assigned. But the reality is that the shares are always welcome back home. I look at the option premiums as being something like the rent you might collect from your adult child living in the basement.

I wanted so much to pick up shares of Baidu (BIDU) once again last week but it just didn’t get to a good price point. By that I mean that as opposed to barely a month or two ago the extraordinarily low volatility is taking its toll on intrinsic value and making the sale of in the money calls somewhat less of a slam dunk, particularly when the intrinsic value is more than half of the difference between two strike prices. I’m hoping to see Baidu trade within $2 or less of a lower strike price early in the week.

YUM Brands (YUM) should probably have the ticker symbol “YOYO.” It responds more to the conflicting daily rumors regarding the vitality of the Chinese economy than do traditional metrics of growth, such as copper and iron ore. Today’s drop was just another in the recent series of rumors regarding safety of the chicken offerings. It’s hard to imagine that YUM Brands is delivering a lower quality or unsafe product than is generally available to the growing consumer base in China.

There was a time, before Apple, that Texas Instruments (TXN) reporting earnings set the tone for the market. Those days are long gone. In fact, no one really sets that tone anymore, not even IBM (IBM), whose own great earnings and share performance did nothing more than be the sole reason for the Dow’s positive performance on Tuesday, while the S&P fell flat. In the meantime, Texas Instruments has survived its own earnings report and has a decent dividend this week in addition to income streams from its weekly option offerings.

Fastenal (FAST) is just a remarkably stable company whose products are ubiquitous yet out of view. Somehow, the fact that they have about 2600 company owned stores has escaped my view, but somehow they haven’t escaped the end user. More important than the company’s stability is the stability of shares over time. The dividend is fairly meager, but added to its option premium a reasonably safe place to leave money for a little while.

US Steel (X) is a recent and current holding. It is among a large group of high profile companies that are reporting earnings this week and may satisfy being plugged in to the equation that evaluates premiums of put sales relative to potential earnings related stock dives. For US Steel accepting the possibility of a 5% decline can still result in a 1% gain.

Lexmark (LXK) was also a recent holding. I still don’t fully understand where their earnings come from now that they are getting out of the printer business. However. it has shown resilience after the revelation that people on wireless devices just aren’t printing as much as the next guy tethered to a desk and computer. It too may offer an appealing award for accepting the possibility of a sharp earnings related decline.

VMWare (VMW), a one time high flier has settled into a good place. Although it is capable of making large moves after earnings, those moves on a percentage basis are fairly modest. Yet it does regularly offer premiums that are attractive. It’s one time parent EMC Corp (EMC) reports earnings in the morning and may offer some insights for the later reporting VMWare.

And finally, there’s Facebook. I still get a little smirk thinking about the vitriol directed toward me when making the case for buying shares following expiration of the first lock-up period. Just as with Apple, your portfolio isn’t a very good place to park your emotions. Whatever your opinion may be on Facebook the shares, Facebook the IPO, Facebook the company or Facebook the hoodie, it is an appealing trade based upon its earnings release this week.

Traditional Stocks: Apple

Momentum Stocks: AIG, Baidu, YUM Brands

Double Dip Dividend: Fastenal (ex-div 1/30), Texas Instruments (ex-div 1/29)

Premiums Enhanced by Earnings: Lexmark (1/29 AM), Facebook (1/30 PM), US Steel (1/29 AM), VMWare (1/28 PM)

Remember, these are just guidelines for the coming week. Some of the above selections may be sent to Option to Profit subscribers as actionable Trading Alerts, most often coupling a share purchase with call option sales. Alerts are sent in adjustment to and consideration of market movements, in an attempt to create a healthy income stream for the week with reduction of trading risk.