January 29, 2005

Handling Earnings Reports
Writing Covered Calls When Earnings are Due
By John

Virtually every day stocks appear on our Real Time Lists™ that will report earnings before option expiration. During earnings season, in fact, many of the stocks on the lists will have earnings reports due. Impending earnings need to be taken into account and careful analysis done, but you don't have to avoid them entirely. This issue explores the dynamics of covered call writing in the face of earnings.

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.

Earnings Terminology and Customs

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.

How Stocks React to Earnings News

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.

Effect of Preannouncements and Guidance Releases

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.

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.

CallWriter Earnings Guidelines

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.

Good luck and good trading!