The trade-off between risk and reward in stocks can be acute right before a company reports its earnings.
X Beat expectations, and the stock can make a good profit for investors who owned it before the report. But if results miss estimates, shareholders are in the hole. One way to have a stake in the results while limiting risk is by using a call option, which gives an investor the right to buy a security at a specified price within a specific time. That’s the way Leaderboard editors chose to add Restaurant Brands (QSR) on the eve of an earnings announcement.
The operator of Burger King and Tim Horton’s restaurants broke out of a flat base April 25 (1). Volume was nearly double its average, the relative strength line was almost at a new high and the base was attractively shaped. In short, the chart was tempting. But the next day, earnings would be delivered. A bad report could quickly make the breakout implode.
The best option to invest was, well, an option. Specifically, Leaderboard editors chose a call option with a strike price at 60, just above the 58.47 where Restaurant Brands closed the day it broke out. If the stock was going to follow through, the option would absorb the additional gains.
But the next day, Restaurant Brands shares tumbled on the earnings report. Shares fell as much as 7% below the 58.08 base entry before paring the loss to 3% (2). By owning the option, Leaderboard was down only the amount paid for the option’s premium, or $80. Even better, the option would not expire until May 19, which gave us the luxury of sitting with the option in case the stock recovered.
Restaurant Brands spent several days finding its way but it eventually recovered to new highs. The option was exercised on the May 19 expiration (3). The stock closed at 60.34 that day and reached a high of 62.45 May 30 (4), so there was a modest profit at that time.
That’s the most valuable lesson from this trade, how an option helped investors navigate a buy opportunity by limiting risk. To be sure, options investors gave up something by paying the premium. But those who bought shares on the April breakout were in the red the next day and would need fortitude to hold.
The trade with Restaurant Brands didn’t go as well after that peak. The stock fell below its 50-day moving average on June 9, as gains from the breakout evaporated. It was sent to Cut List. But it went right back on the Leaders list a few days later when shares rose back above the 50-day line. Shares traded sideways for weeks then eased below the 50-day line one more time. Restaurant Brands went on the Cut List for good Aug. 1 at 59.13.
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