With the stock market closed Monday due to the Christmas holiday, the coming week is especially light on earnings.
X But as New Year’s resolutions approach, a good one for stock investors is to learn how to implement an easy-to-use options strategy around earnings in which you don’t have to shell out a lot of money to profit from a stock’s gain. You’re also shielded from a big loss if the trade doesn’t go as planned, because the loss is always capped at the amount paid for the contract.
One call option gives the holder the right to buy 100 shares of a stock at a specified price, known as the strike price. A put option is a bearish bet, and one contract gives the holder the right to sell 100 shares of a stock at a specified strike price. Stocks trade either weekly or monthly options, and every option contract comes with an expiration date.
In the latest week, Darden Restaurants (DRI) worked out as a call-option trade. Just ahead of its report, the Olive Garden and LongHorn Steakhouse parent was still in buy range from an 88.67 cup-with-handle buy point.
When shares were trading around 88.75, a monthly call option with a slightly out-of-the-money 90 strike price (Jan. 19 expiration) came with a premium of around $2.70, presenting a trade with reasonable downside risk of 3% (2.70/88.75).
The trade gave the holder the right to buy 100 shares of Darden at a 90 strike price for a cost of $270, excluding commission. Darden on Tuesday opened at 93.81 after earnings, sales and same-stores sales all topped expectations. Shares closed at 96.69 up nearly 7%. When taking the cost of the premium into account, the trade became profitable when Darden hit 92.70.
Wall Street was also pleased with results from FedEx (FDX), but the stock was extended past a proper buy point just ahead of earnings, making it a riskier option play. The last time FedEx was buyable was when it reclaimed the 50-day moving average in late November.
Remember that the call-option strategy should only be used with stocks that are near buy points, either after a base breakout or still in range from alternate entry such as a pullback to the 50-day line. Look for a slightly out-of-the-money strike price that’s just above the underlying stock price. Target trades where downside risk is limited to 4% of the underlying stock price. In some cases, looking at a slightly in-the-money strike price makes sense so long as it’s reasonably priced.
FedEx offered a good example in the latest week. Optimism was high ahead of its earnings report, especially after the company in early November forecast a record holiday season, predicting volume of 380 million to 400 million packages.
But after a nice pre-earnings rally, option traders weren’t expecting the stock to move much. When shares were trading around 242.75 on Tuesday, a weekly call option with a slightly in-the-money strike price of 242.50 (Dec. 22 expiration) came with a premium of around $4, offering a trade with minimal downside risk of 1.6% (4/242.75).
FedEx opened Wednesday at 252.60 and closed at 251.07, up 3.5%.
Next week, this space will look back on several winning earnings options trades in 2017, including homebuilder KB Home (KBH) in January, Ollie’s Bargain Outlet (OLLI) in March and PayPal (PYPL) in late April.
Finally, a quick word about the overall health of the broad market as we head into 2018: While there’s still plenty to like about the confirmed market uptrend, yellow flags are out there that have to be considered when developing a bullish or bearish thesis going forward.
The bulls like the sound of big tax cuts for U.S. corporations that will surely make their way to the bottom line, which should provide a good foundation for continued earnings growth in coming quarters. Meanwhile, even if interest rates continue to edge higher (the Fed is currently projecting three rate hikes in 2018), rates will be still be relatively low, which should fuel continued M&A activity and a healthy environment for IPOs.
The bulls also like the fact there are plenty of bullish stock charts to consider out there, with damage to leading growth stocks minimal at this point.
The bears don’t have much to hang their hat on at this point. The distribution-day count for the Nasdaq and S&P 500 is the smallest it’s been in a while, meaning that institutional investors have generally been sitting tight in positions. There’s been some selling in the semiconductor space recently, and FANG names like Facebook (FB) and Netflix (NFLX) look a bit tired, but there are plenty of other growth stocks with strong charts. Leading financials continue to trade tightly near highs and some biotechs are starting to show renewed signs of life.
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