Only two companies with weekly options announce earnings this week, Nike (NKE) and Accenture (ACN), both announcing Thursday after the close.  We could not get a good read on NKE (expectations did not seem unusually high or low so we couldn’t get a good handle on the possible direction the stock might take).  Even worse, NKE has a history of very large percentage changes after announcing, so if we were wrong on our directional guess, we could be in big trouble.ACN is a little more hopeful, and we will place a PEA Play (Pre-Earnings Announcement) on it either Wednesday or Thursday.

Terry

How to Play the Accenture Earnings Announcement Thursday

Accenture was founded in 1995 and is based in Dublin, Ireland.  It provides management consulting, technology, and business process outsourcing services worldwide.   Here are the numbers for ICN for the last four announcements:

ACN Whisper Numbers

The company met or beat estimates every quarter but once, and that time the stock fell 3.1% after the announcement. The stock moved higher from about $75 after the last quarterly announcement to a new high of $84.23 four weeks ago but has fallen back to about $79.80 since that time, suggesting that expectations have receded a bit.  RSI is at 44, in a neutral state.Insiders sold 16.8% of their holdings (388,854) over the last six months, a little on the high side, while institutions added 566,683 over the last quarter, a bullish signal (although on a base of 650 million shares outstanding, these numbers are not terribly significant).

The company sports a forward p/e of 17.11 which does not seem too high considering that it has maintained a steady growth of revenues and earnings for many years.  The stock has doubled in value over the past 2 ½ years.  It pays a 2% dividend which should help ward off a very large drop in the stock price.

Bottom line, in spite of whisper numbers exceeding estimates by a fair margin, expectations do not seem terribly high, especially with the recent drop in the stock price.  The company has been quite consistent in beating estimates, so it seems unlikely that there should be a big drop in the stock price after the announcement.  On the other hand, with the whisper numbers higher than estimates, there seems to be only a small chance of a big run-up in the stock.

This is the risk profile graph for two diagonal spreads (10 contracts eac), buying July 82.5 calls and selling Jun4-13 80 calls for a credit ($.40 as I write this) and buying July 75 puts and selling Jun4-13 77.5  puts for a small debit ($.05 as I write this), incurring a $2500 maintenance requirement,  assuming that IV of the August options falls by 3 after the announcement:

ACN Risk Profile Graph

It will be interesting to see how this sugars out at the close on Friday when we will most likely close out all the positions.

Last week our string of 12 consecutive winning PEA Plays (Pre-Earnings Announcement) was broken, not because our model guessed wrong on where the stock (LULU) would go after the announcement (down, as it did), but because the CEO announced her retirement and the stock fell almost 20% on that news (the company actually exceeded estimates on earnings, revenues, and guidance but the retirement news overshadowed that good news).  Our option positions were set up to handle a 7% drop and still make a gain, but we could not handle a 20% drop.

Interestingly, our loss came about not from our basic diagonal spread (where we would have made money in spite of the huge drop) but from the insurance calendar spreads we placed “just in case we were wrong” about the direction the stock would take.  If we had had more faith in our model, we would not have made the insurance purchase, and we would not have suffered a loss.

Our loss on LULU was slightly greater than the average gain we made on the 12 previous PEA Plays, so while it was an unpleasant setback, it was not devastating.

Terry

How to Make a Portfolio of Calendar Spreads Either Bearish or Bullish: 

At Terry’s Tips, we use an options strategy that consists of owning calendar (aka time) spreads at many different strike prices, both above and below the stock price. A calendar spread is created when you buy an option with a longer lifespan than the short option that you sell against your long position with both options at the same strike price. We also use diagonal spreads which are similar to calendar spreads (except that the strike prices of the long and short sides are different). 

We typically start out each week or month with a slightly bullish posture since the market has historically moved higher more times than it has fallen.  In option terms, this is called being positive net delta.  Starting in May and extending through August, we usually start out with a slightly bearish posture (negative net delta) in deference to the “sell in May” adage. 

Any calendar spread makes its maximum gain if the stock ends up on expiration day exactly at the strike price of the calendar spread.  As the market moves either up or down, adding new spreads at different strikes is essentially placing a new bet at the new strike price.  In other words, you hope the market will move toward that strike.

If the market moves higher, we add new calendar spreads at a strike which is higher than the stock price (and vice versa if the market moves lower).  New spreads at strikes higher than the stock price are bullish bets and new spreads at strikes below the stock price are bearish bets.

It does not make any difference whether puts or calls are used for a calendar spread – the risk profile is identical for both.  The key variable for calendar spreads is the strike price rather than whether puts or calls.  In spite of that truth, we prefer to use puts when buying calendar spreads at strikes below the stock price and calls when buying calendar spreads at strikes above the stock price because it is easier to trade out of out-of-the-money options when the short options expire.

If the market moves higher when we are positive net delta, we should make gains because of our positive delta condition (in addition to decay gains that should take place regardless of what the market does).  If the market moves lower when we are positive net delta, we would lose portfolio value because of the bullish delta condition, but some or all of these losses would be offset by the daily gains we enjoy from theta (the net daily decay of all the options).

Another variable affects calendar spread portfolio values.  Option prices (VIX) may rise or fall in general.  VIX typically falls with a rising market and moves higher when the market tanks.  While not as important as the net delta value, lower VIX levels tend to depress calendar spread portfolio values (and rising VIX levels tend to improve calendar spread portfolio values).  

Once again, trading options is more complicated than trading stock, but can be considerably more interesting, challenging, and ultimately profitable than the simple purchase of stock or mutual funds.

Yesterday I sent out suggested trades for LULU’s Monday earnings announcement.  The stock has rallied over $2.50 since then, and we have raised our strike prices by 2 ½ and placed the following trades today:

June 7, 2013 Trade Alert –  PEA Picker  Portfolio – limit orders

LULU announces earnings after the close on Monday and we will get these orders in today, committing a little over half our money:

BTO (buy to open) 10 LULU Jul-13 82.5 calls (LULU130720C82.5)

STO (sell to open) 10 LULU Jun2-13 80 calls (LULU130607C80) for a debit limit of $.25  (buying a diagonal)

BTO 5 LULU Jul-13 85 calls (LULU130720C85)

STO 5 LULU Jun2-13 85 calls (LULU130607C85) for a debit limit of $1.37  (buying a calendar)

Happy trading.

Terry

This article was submitted to Seeking Alpha but was declined because it focused on options.  I thought you might like to see it.

This quarter’s earnings season is winding down.  Only one company with weekly options available, Lululemon Athletica (LULU) is due to report next week.  (I restrict my analysis to companies with weekly options because they are the most actively-traded and popular, and I often employ the weekly options in my trading.)  LULU reports on Monday, June 10 after the closing bell.

LULU is a high-end retailer of fitness apparel including fitness pants, shorts, tops, and jackets for healthy lifestyle activities, such as yoga, running, and general fitness. Based in Vancouver, British Columbia, LULU has 135 stores in the United States and 51 stores in Canada, and also has extensive wholesale business through health and fitness clubs.

Not only are its clothes high-end, so is its p/e ratio, 42.47, which compares to Nike’s (NKE) 24.11.  This lofty evaluation is the likely reason for the large number of shares sold short (19.8% of the float).

Looking forward to next week’s earnings announcement, let’s check out what has happened over the past four quarters, with the stock price change from the close on the day before the announcement until the closing price on Friday (when the weekly options expire):   

LULU Earnings Chart

LULU has not done very well after earnings announcements considering they beat estimates every time.  In half the quarters the stock fell after they topped estimates. The stock has tended to move considerably after an announcement (an average of 7%). Next week’s option prices are priced for a 7% move, exactly the average change for the last four quarters.

Over the last several months, I have been testing the proposition that the level of expectations prior to an earnings announcement is a better indicator of what the stock price will do than the actual earnings themselves. I call it the Expectation Model.   Basically, I examine recent stock price activity, estimates vs. whisper numbers, past post-earnings price changes vs. results, current RSI levels, and come up with a measure of whether expectations are unusually high or low. If expectations are usually high, there is an excellent chance that the stock will be flat or fall after the announcement, regardless of how much the company might surpass estimates, and conversely, the stock is more likely to move higher when expectations are low, even if estimates are merely met.  (Unusually low expectations are generally less predictive of higher post-announcement prices, however – unusually high expectations more reliably predict lower prices after the announcement). I have had some serious success with this model, including 12 consecutive winning pre-earnings calls (average gain about 18%) without a loss – see results and update. Over half of the earnings plays were published in Seeking Alpha articles published before the announcement – see some examples here and here.

A bullish case for the company cited getting its yoga pant line back after recalling it for being too transparent – Lululemon Poised To Pop After Ironing Out Pants Issue. A more balanced analysis was made by Bill Maurer –  Will Lululemon Decline After Earnings?  I strongly encourage you to read this article as he reported just about exactly what I would have said so there is no reason to repeat it all here.

The only thing I would add to Bill Maurer’s article is my concern of the level of recent insider and institutional sales of stock.  While Yahoo reports that insiders sold 579,758 (4.2% of their holdings) over the past six months, if you add up the individual sales reported that number becomes more than double that amount.  Over the last quarter, institutions disposed of over 7 million shares (4.9%) of their holdings.

So how does LULU stack up with the Expectation Model?  Bottom line, expectations seems to be a little high leading up to next week’s announcement.  The stock has had a huge run-up recently, rising about 25% over the past 10 weeks and hitting a new high of $82.48 last week before backing off about $4 since then.  Whisper numbers are higher ($.32) than estimates ($.30). Recent institutional sales or purchases are part of the model and have been a fairly reliable indicator as to how the price might move after the announcement.  We can expect that a great deal of research and analysis went into their decision (in this case, to sell shares) and it is usually a good idea to follow along with them rather than guess they are wrong.

High expectations, a record of lower stock prices after earnings, and what I believe is a currently-expensive stock price, all lead me to believe that there is an excellent chance that LULU will trade lower next week and that anyone who is thinking of buying shares should wait until after the announcement and most likely get a better price at that time.  This is just what I said about Costco (COST) two weeks ago (a company I love and am long), and even though it bested estimates, it is trading about $5 lower after announcing.

I don’t feel as strongly that LULU will drop after the announcement as I did with COST, however (mostly due to the stock falling $4 in the last week), so I will hedge my bet.  With LULU trading at $79, I will buy 10 July-13 80 calls and sell 10 Jun2-13 78.5 calls (incurring a maintenance requirement of $2500) for about even money, and buy 5 July-13 – Jun2-13 82.5 call calendar spreads for about $1.25 (just in case I am wrong and the stock moves higher).  My total investment will be about $3200.

Here is the risk profile graph for those positions assuming that IV of the July option will fall from 40 to 30 after the announcement:

LULU Risk Profile Graph

These positions could make an average gain of about 20% if the stock does not fluctuate too much.  It looks like a gain of some sort should come about if the stock fluctuates by less than 5% on the upside or about 7% on the downside.  This is an investment you should only make with money that you can truly afford to lose.  I plan to do it, and expect it to be my 13^th consecutive winning earnings trade.

Last week I wrote two Seeking Alpha articles on earnings plays – How To Play The Costco Earnings Announcement and How To Play Joy Global’s Earnings Announcement.  I expected that Costco would fall after earnings because expectations were unusually high and that JOY would move higher because expectations were quite low.

I was right on with the COST call and our positions gained 16.6% after commissions for the week.  JOY fell marginally, less than $.50 and we gained 7.8%.

Update on the Costco trade (submitted as a comment after the Costco article). Today before the open, Costco announced earnings of $1.04 which beat estimates of $1.02 but fell short of the $1.06 whisper number. The stock is now trading just under $113 compared to just under $115 when I wrote this article so any potential buyer of the stock would have done well to heed my advice and wait until after the announcement to buy shares (Note: a day later fell to below $110).

The diagonal option spread that I suggested was sold in our Terry’s Tips portfolio for a credit of $.84. That meant for anyone buying 5 spreads, your investment would have been the $2500 maintenance requirement less $420 received from the sale, or $2080. Today we sold the spread for a debit of $.10, making $.74 per spread. After paying commissions of $25, the net gain on 5 spreads was $345, or 16.6% on the investment. This was the 11th consecutive successful earnings trade we have made using our Expectation Model.

Note: In the actual Terry’s Tips portfolio where the Costco trade was made, we also placed a calendar spread to reduce our risk (in case we were wrong about Costco falling after the announcement).  This spread lost money and reduced our gain to 9.6% after commissions.

In JOY there were 4 July-13 – May5-13 calendar spreads. In our actual account at thinkorswim, here are the numbers for what we paid for these spreads and what we sold them for: 52.5 strike (cost $1.35 sold for $1.20), 55 strike (cost $1.55 sold for $2.38), 57.5 strike (cost $1.50 sold for $1.61), and 60 strike (cost $1.19 sold for $1.00). We lost money on 2 spreads but gained on 2 others, and enjoyed one big gain. The total cost of our investment was $2236 and our net gain after paying $65 in commissions was $175, or 7.8% on our investment.

While this was quite a bit lower than the returns we made on the earlier 11 investments that resulted in gains averaging about 19% (without a single loss), most people would be happy with 7.8% for a single week after commissions. 

These two profitable earnings trades made it 12 consecutive gainers for this portfolio.
The odds of making 12 successful profitable trades without a single loss is comparable to flipping a coin and getting heads 12 times in a row. The odds of that happening are one out of 4096 times. Either I have been incredibly lucky or maybe there is some merit in the Expectations Model I have developed. The future will tell. 

We are not making any earnings-related trades this week because only one company we are following (they must have weekly options and be trading over $20) reports this week, and our expectations model could not determine whether expectations were unusually high or low.