This is the best strategy after earnings disappoint
Time for another out of
the money call credit spread.
When Best Buy Co.
(
BBY |
Quote |
Chart |
News |
PowerRating) missed its second
quarter earnings target Tuesday, and downgraded its forecast for third quarter
earnings, the nation’s largest consumer electronics retail company took a
licking.
This kind of news can often keep the bulls at bay
for at least one full quarter until earnings results are announced again,
offering up a reliable setup for an out of the money call credit spread.
Figure 1 shows the large gap lower on
Tuesday, 9/13/05. The big drop was followed by a small gain on Wednesday,
leaving the stock at 44.79, 10.9% below the pre-gap close price.
Figure 1 — Generated using OptionVue 5 Options
Analysis Software
As I’ve written in previous articles, I like to
sell a call near the pre-gap close (preferably a little higher) because this
will provide good resistance should the stock price attempt to climb back
because investors who did not get a chance to sell will most likely sell into
rallies back into the gap.
Therefore, I will sell a December 50 call for
$115 and cover it with a December 55 long call for $40. This will give me a net
credit of $75 for each spread I put on, with a maximum risk per spread of $425
(the size of the spread minus premium collected) if the position suffers from a
price move back above the short strike (Dec. 50) and all the way to the long
strike (Dec. 55). If the stock remains below 50 by expiration on December 17,
this trade makes 17.65% profit.
But we will use a doubling of the credit as a
mental stop loss for closing the trade, or if the price of BBY touches the short
strike, we will close the trade. This keeps losses manageable.
Figure 2 shows the profit/loss parameters
for this trade, with breakeven at 50.75, just above the pre-gap close price of
50.36.
Figure 2 — Generated using OptionVue 5 Options
Analysis Software
If you do these kinds of trades, be sure to risk
no more than 3-5% of your trading capital per trade. And it is always good to
have both bullish and bearish trades in your portfolio of positions to balance
out the beta risk.
Finally, it sometimes pays off to wait for a one
day bounce before putting on the spread just to provide an additional edge to
the position.
Good luck with your trading!
John Summa, CTA
John F. Summa is Founder and President of
OptionsNerd.com,
and a registered Commodity Trading Advisor (CTA) with the National Futures
Association (NFA). Founded in 1998, OptionsNerd.com offers trading
seminars and tutorials to options traders, futures and option trading
advisories and managed futures and options CTA account services.
Mr
Summa’s trading articles have appeared in Technical Analysis of Stocks &
Commodities magazine, as well as Active Trader Magazine, Options Trader
Magazine, Futures Magazine, Stock, Futures & Options Magazine, and Investopedia.com. He coauthored
Options on Futures: New
Trading Strategies and Options on Futures Workbook (John Wiley & Sons, 2001) and more recently wrote the groundbreaking
book,
Trading
Against The Crowd: Profiting From Fear and Greed in Stock, Futures and
Options Markets (John Wiley & Sons,
2004), which includes Mr. Summa’s innovative quantitative bear and bull
news-flow Contrarian indicator. Mr. Summa is a PhD-trained economist
and operates a
delta-neutral options trading CTA program.
Attend John’s Upcoming Seminar:
To learn how to trade options correctly, visit John’s website,
OptionsNerd.com! He offers free and
premium options education seminars, as well as an equity index options spread
trading advisory. John will be presenting his next intensive options seminar in
Chicago on September 23, 2005. To learn more about this event, please
click here
for more info.