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An
extra, and important, variable is present when one writes
covered calls on stocks reporting earnings before expiration
- the stock's potential reaction to the earnings. While
there is no way to be certain how a stock will react to
an upcoming earnings report, there is a method I've developed
to assess the special risk posed by the earnings announcement.
The
money that a profitable company makes is referred to as
its earnings. A commonly used metric for comparing
earnings – and the one the market focuses on - is
earnings per share, which is the company's total
earnings divided by the number of shares outstanding.
Public companies release earnings four times a year, after
each quarter's end. The earnings report after the 4th
quarter wraps up the entire year. Companies announce well
in advance when earnings will be released (this date can
be revised one or more times), and calls and puts frequently
get quite expensive on stocks waiting for earnings releases.
This is natural, since the market expects that a stock
may move on earnings news and is always willing to pay
more for options on a stock likely to move. The call writer
can exploit the high premium, provided due care is used.
Wall
Street stock analysts take the guidance information provided
by companies and prepare their own estimates of likely
earnings. The various estimates reached by analysts are
averaged and a consensus estimate is reached. The
two companies of primary importance in the earnings estimates
business are Thomson First Call and Zack's.
Investors and traders sometimes also reach their own estimates
of likely earnings, known as the whisper number,
which can be disseminated through forums and websites
such as EarningsWhispers
and WhisperNumber
(requires registration to use, but it's free), but the
impact of today's whisper numbers on prices is widely
debated.
Preannouncements of earnings are becoming more common.
An earnings preannouncement is the company’s
public statement about an upcoming earnings announcement
made shortly before - usually a few weeks before - the
official announcement. Managers use them as "mid-course
corrections" to provide analysts and the investing
public a heads-up in order to lessen the impact on stock
price. Managers most commonly use preannouncements when
the earnings number they will ultimately report is very
far from analysts' earnings forecasts, when there is a
large variation in analysts' forecasts, or when managers
have bad news. Trading preannouncements is a dicey business,
because most of them don’t pan out, whether bearish
or bullish. However, a positive preannouncement may provide
some comfort against an earnings surprise.
And
we are contending only with current earnings. Sometimes
in tandem with the earnings report, a company will release
forward-looking earnings estimates (“guidance”
releases) for the next quarter or longer future period.
It is not uncommon for companies releasing earnings after
the 4th quarter to give guidance for most or all of the
coming year, which is why the 4th quarter earnings season
is the diciest of all for a call writer to hold through.
So,
what does it all mean? As you may have already realized,
the key number is the analyst community's consensus earnings-per-share
(EPS) estimate. When a company fails to meet the consensus
number - known as an earnings surprise - sometimes
by as little as even a penny, the stock can pull back,
even undergo a major selloff. On any earnings surprise,
a sell-off can occur and is likely - - only the extent
of the sell-off really is in question. A stock that has
advanced on pre-announcement expectation may run up even
further if the news is better than expected, but it isn't
likely, especially nowadays. Stocks frequently move up
on earnings anticipation and then sell off even when they
DO make their earnings numbers, either because the company
did not hit analysts’ higher consensus earnings
number or because everyone who wanted the stock has already
bought it (buy on rumor, sell on news).
That
is, when the stock has run up pre-announcement, the finest
performance likely has already been baked into the stock,
so there's nowhere for it to go in the short term. It
is likely that a stock which advanced on anticipation
will give it up; while this will not always happen, it
is wise for the covered call trader to figure on it.
Companies
now do such a good job of managing earnings and the market's
earnings expectations that you just don’t see huge
earnings surprises much any more. Surprises produce huge
lawsuits, and sometimes investigations, and whipsaw stocks,
so companies really don't want to hide the ball as a usual
thing. And when the market indices are up, indicating
that stocks are fully valued, it would have to be a really
huge surprise to send a stock skyrocketing. Like others,
I've noticed in 2005 that stocks are tending to sell off
before the announcement. It may be that the market
is treating the earnings report as a foregone conclusion,
as one writer has suggested, in which case a pre-announcement
sell-off makes sense. Once traders realize that stocks
which run up pre-announcement tend to give up the advance
post-announcement, it was only a matter of time before
the sell-offs began before the announcement.
They're
still selling off, only before announcing instead
of after. The “sell off” may not be all that
great, and the sell-off will not usually persist over
the long term. A company like Microsoft (which sold off
pre-announcement in 2005) typically will rebound. Smaller
and weaker companies might not, or the rebound might take
years.
One
Harvard Business School study found that companies release
earnings news through both preannouncements
and actual earnings announcements, but that from
the perspectives of both analysts and investors, more
information is conveyed in preannouncements. Analysts
and investors also seem to regard bad news preannouncements
as more informative than good news preannouncements, which
is consistent with the fact that bad news preannouncements
tend to be farther away from expectations. In other words,
analysts' earnings estimates are getting less and less
weight from traders and investors, which are instead relying
more on the company's preannouncement numbers. Another
study found that company preannouncement numbers are more
accurate than analysts' earnings estimates prepared using
the company's preannouncement numbers! Yow, if I didn't
have much respect for analysts before...
Guidance
releases, on the other hand, can have a huge bearing on
the stock price. If the guidance or any trends discerned
by the market indicate negative future results, the stock
price will be immediately affected. In fact, small-cap
and mid-cap companies trading at high P/E ratios can collapse.
Example: Lexar Media (LEXR) was a market
darling in 2003 and early 2004 until it released guidance
after Q4 of 2003 indicating that management expected
substantial revenue growth in 2004 but a lower profit
margin and perhaps a loss. The stock fell from $15 to
$5 and in the next twelve months never got above $10.45.
This is one reason for care when it comes to smaller
technology companies and stocks with high P/E ratios,
much less both together!
To
sum up, stocks reporting earnings before option expiration
pose three very real dangers to the covered call writer:
| 1. |
The
earnings report does not meet market expectations
(the consensus number), causing the stock to sell
off. |
| 2. |
The
market "buys the rumor and sells the news"
on an earnings play, causing the stock to sell
off even when the company makes the consensus
number. |
| 3. |
Forward-looking
guidance information released at the same time
can affect the price, even lead to a major sell-off.
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If
at this point you're thinking, "wait a minute, the
stock sells off either way," I feel your pain. But
by no means do stocks always sell off. More often
than not, they don't. When the economy is bad, most companies
report lower than expected earnings. And for that matter,
an industry or entire sector can be off its feed, in which
case earnings expectations will be lower for the sector
or industry (but woe to the company that fails to keep
up with the pack's diminished expectations). When the
market is seeing bad earnings everywhere, the market tends
to sell off. And poor earnings will cause an industry
or sector to sell off, in which case earnings expectations
will be lower for the sector or industry (but woe to the
company that fails to keep up with the diminished expectations
for the pack).
As
with so many things in trading, there simply is no
way to precisely predict any stock's reaction to impending
earnings news. We don't know what the earnings report
will be, although the preannouncement release will provide
a fairly good idea, and we cannot know how the market
will react to whatever it is.
Scary,
huh? I don't avoid a stock about to report earnings just
for that reason, but it adds a potential complication.
This is why one of the first things i look at is whether
earnings will be reported before the expiration date.
Here are some guidelines I use that may help to refine
your analysis of stocks about to release earnings:
| What
is the quality of the company? |
The
larger the company and the more stable the stock,
the less likely it is to pull back on an earnings
report. Stocks trading at P/E ratios that are significantly
higher than industry average are particularly vulnerable
to poor earnings news, and to market pullbacks in
general. All things being equal, stocks trading
at a P/E and P/S (price to sales ratio) that are
more in line with the industry tend to be more stable,
absent a poor history of reaction to earnings releases.
The smaller the company, the weaker its spine. |
| Study
the company's earnings history |
While
we can never be sure if a company will hit its
guidance number (or a higher consensus number),
we can look back at the last year or two of charts
and see how the stock has reacted to previous
announcements. As Dr. Phil says, the best predictor
of future behavior is past behavior, and that
holds true for stocks as well. If earnings will
be reported before expiration, it is crucial to
look at a couple years' worth of charts to see
how the stock handles earnings announcements.
If it tends not to sell off on earnings announcements,
it is a far safer bet than companies that do sell
off. Some stocks have a tendency to sell off somewhat.
But even in that event, look at the typical recovery
period. All that may be required to safely
write the company is to go well into the money
with the calls or simply write ITM a month or
two out. That way if the stock pulls back, you
are well protected and can close profitably or
roll into a more advantageous call.
Some
stocks do not have a consistent reaction to earnings
news; sometimes up, sometimes down. These I consider
earnings-volatile and also avoid. |
| How
are earnings for its industry overall? |
If
the company’s industry is struggling (e.g.,
airline companies hit by surges in fuel prices),
then you can reasonably expect a mediocre earnings
report. I get very concerned about an entire industry,
or even an entire sector going into rotation (selling
off) when earnings are bad across the board. But
use common sense – if the industry has already
sold off, then the danger of a sell-off is comparatively
low unless the company disappoints even the low
expectations for companies in that industry. If
the industry is making money, it augurs well for
the company itself, although research is in order,
as the next paragraph indicates. |
| Price
move up on earnings anticipation? |
This usually is evidenced by a recent increase in
price that is not attributable to other factors
– which requires a bit of research into the
recent news. The more it has run up, the more likely
it will sell off, or at least pull back, as traders
sell the news (whether before or after the announcement).
You have to get a handle on this if you write earnings
plays that have moved up on anticipation –
they usually sell off. I don't touch these unless
I’m writing well in the money, 10% ITM or
more. |
| Unprofitable
companies |
Unprofitable
companies trading on future earnings (or on air)
are less susceptible to earnings reports than
companies that are earnings-driven since they
don't have earnings. However, if the company has
forecast a lower loss or other improvement in
its prospects, the market will hold the stock
to it. The comments about high-fliers above are
applicable here, also. It doesn't get any higher-flying
than an unprofitable company highly priced. Not
only that, the money-losers are highly susceptible
to a market pullback or an industry sell-off.
The
exception is a large company that is a leader
in its industry and currently unprofitable but
expected to return to profitability. |
| Bellwether
stocks |
Many
stocks, especially small- and mid-caps, tend to
follow a much larger stock, perhaps one of the
industry leaders - the "bellwether"
stocks. If the stock you are considering closely
follows the fortunes of a larger stock, it is
wise to make sure the bellwether stock is not
reporting earnings, or at least assess the risk
posed. It is no fun to have a stock pull back
hard on no news, only to realize the company is
doing fine and simply following a bigger dog with
an earnings disappointment.
For
example, flagging sales at a bellwether personal
computer chip manufacturer could indicate a decline
in overall demand for computers and related products.
If investors think the manufacturer's results
forecast problems for other companies in the sector,
this could affect stock prices for those businesses,
even if they have not issued negative reports.
This happens frequently when bellwether companies
like Dell or Microsoft report. |
| Industry
watch |
If
the industry or sector seems in trouble or is being
viewed askance by Wall Street, be extra careful.
If other companies in the industry have reported
negative earnings, definitely do more research. |
| Plan
an early exit |
A
tactic practiced by many covered call writers who
write companies about to release earnings is to
plan to exit the trade the day before earnings,
or even the day of earnings, where earnings are
reported after the bell. Especially if the stock
has moved up, many times the trade can be profitably
unwound. |
To
sum up, an impending earnings announcement is cause for
concern, and if you blindly write stocks without checking
for an earnings report, you will take some hits. On the
plus side, it is comparatively rare for an earnings release
to crater a stock, unless the news is catastrophic. In
my experience, other news tends to affect stocks much
harder, such as poor clinical trial results on a crucial
drug and major lawsuits. A study by options guru Larry
McMillan done on straddle plays (buy the call and put)
and published in Active Trader Magazine, concluded
that earnings plays were among the poorest performing
of all news events for straddle buyers. This indicates
that the pop stocks undergo at earnings generally is not
that great.
One
technique that can be used on stocks moving up on earnings
anticipation is to leg in to a protective put. A protective
put is of course the purchase of a put to protect in the
event of a pullback in the stock. But instead of writing
the put upon creation of the covered call, we wait until
closer to the announcement date. The reason is that the
higher the stock moves, the further out of the money (and
thus the cheaper) the put will become. Suppose the stock
is at $21.50 and we write the 22.5 Call, intending to
hold the stock through earnings. Yet purchasing the 20
Put will be expensive and eat up a lot of our call premium.
If the stock is moving up, we can wait a week or so to
buy the 20 Put in hopes that it will become cheaper through
a combination of time decay and the put falling further
OTM.
Therefore,
you need not avoid a stock solely due to earnings news.
As noted, other news events can be far more dire.
And as the above punchlist indicates, you have tools with
which to evaluate stocks about to report, including the
simple expedient of closing the trade right before earnings.
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