In our BCI methodology, our covered call writing strategy has several guidelines and one rule. The rule is to never sell a covered call option when there is an upcoming earnings report prior to expiration. Some may ask why not? With the added volatility are our options not going to generate additional premium and if the report disappoints will not the premium help mitigate losses? True and true but the rule stands.
First a little history. When I started teaching myself this strategy in the early 1990s I would find that periodically one stock’s price decline would wipe out my entire month’s option profits. I would always research the cause and more often than not it was a disappointing earnings report. I, like you, don’t like to lose money so ultimately I created the rule and the number of catastrophic gap downs decreased dramatically (they will, however, still pop up from time to time).
What can cause a gap down?
So what is it about these reports that can create a gap-down? Why is it that a company can have a stellar report and still decline in price? Market reaction, to a great extent, is based on analyst expectations or consensus. If a company’s earnings and revenues rose by 20% year-to-year but the market was anticipating 25%, look out below. Then there’s the whisper number. This is the unofficial, unpublished earnings forecasts that circulate among professionals on Wall Street. This number may be different from consensus and can impact market interpretation of a report. There is als0 corporate guidance where a company forecasts future earnings and revenues. This too can be a source of market disappointment. Finally, the report can simply disappoint and not meet consensus expectations. The point here is that so much can go wrong and we are generally conservative investors, using a low-risk strategy with capital preservation a critical goal. Why take the chance?
A little math
The implied volatility of an option reflects the market anticipation of price movement by expiration. It is greater when earnings are due to be reported prior to expiration. Let’s say in a non-ER month a stock traditionally trades in a $4 price range. So a stock trading @ $38 can trade between $36 and $40. Writing a $40 call for $1.60 on an uptrending stock with strong fundamentals is a low-risk sound investment. Now let’s say earnings is approaching and the market is anticipating a drop as low as $30 or a move up as high as $46, a $16 range. Selling that same $40 will limit the upside to $2 but protect the downside by only the premium generated. We are exposed to greater risk when we had the date that could have been avoided.
What if the report does not disappoint and I still like the stock?
Time to get on board. You now have two months to use this great-performer after the volatility of the report passes. Never look back and say what could have been. But rather congratulate yourself for circumventing a potential disaster. The cash you would have spent on this stock didn’t go to waste. You used it with another financial soldier…a safer one.
What if I think the report will be a positive one?
Okay so now we’re getting away from covered call writing but I must admit that from time to time I will own a stock through an earnings report. Years ago I did this frequently with CSCO and AAPL with huge success. Although it is not part of our BCI methodology when a stock is owned through a report, we take full advantage of the positive surprise (the last few years there have been more positive than negative surprises) and then write the call after the report passes and get the best of both worlds. However, be prepared that you could be wrong and get spanked with this approach if the report disappoints.
Here is a chart of YNDX, a stock frequently found on our premium watch list showing both a gap up and a gap down resulting from earnings reports:
Premium Member Stock Reports highlight earnings dates for the current month in gold rows with the projected dates for all eligible stocks in the column next to the ticker symbols:
Never write a covered call on a stock with an upcoming earnings report. If you feel strongly about owning the stock through the report or own it in a long-term buy and hold portfolio, write the call after the report passes. Some stocks have weekly options which will allow you to write call up to the actual week of the report.
New stock report video:
Our membership has grown dramatically in the past few months (Thank you!) and several new members have been inquiring about the content of the enhanced stock reports. I recently produced a new video where we can “take a tour” of the latest stock reports. Go to the link below and scroll down to the top video:
New seminars just added:
- September 17, 2014: Madison, Wisconsin
- September 18, 2014: Milwaukee, Wisconsin
- October 27, 2014: Austin, Texas
- March 18, 2015: Orlando, Florida
- March 19, 2015: Sarasota, Florida (afternoon)
- March 19, 2015: Venice, Florida (evening)
Next live seminar:
World Money Show, Orlando, Florida:
Economic reports this past week were generally favorable giving this site no reason to change its bullish overall economic stance:
- The Consumer Price Index (a widely followed indicator of inflation. The CPI is a measure of the average change over time in the prices paid by urban consumers for a fixed market basket of consumer goods and services. The “core” CPI excludes food and energy prices, which account for roughly one-quarter of the broad CPI and tend to fluctuate widely, providing a truer reflection of inflationary trends) rose 0.3% in December, the first rise in 3 months
- For 2013, prices were up 1.5% and core prices 1.7%, both below the Federal Reserve’s 2% target rate for inflation
- The Producer Price Index (PPI), a measure of wholesale prices increased by 0.4% in December, the largest increase since June, 2013
- The overall PPI rose by just 1.2% in 2013, the smallest calendar-year increase since 2008
- Retail sales moved up by 0.2% in December, double analyst expectations. Excluding auto sales (down 1.8% due to weather conditions) sales were up 0.7%, the best growth since February, 2013
- Overall retail sales rose by 4.3% in 2013
- The Federal reserve’s beige book which depicts economic activity from the central bank’s 12 districts, showed moderate expansion from late November through the end of 2013. Rising interest rates was a concern in this report
- New home construction dropped by 9.8% in December, related to the weather conditions, but was up 18.3% in 2013
- The number of new housing starts was at its strongest since 2007
- The number of building permits rose by 17.5% in 2013
- Construction of single-family homes was at its strongest since May, 2008
- Business inventories rose by 0.4% in December, better than the 0.3% expected
- Industrial production was up 0.3% in December, largely due to manufacturing and mining and showed a yearly gain of 3.7%
For the week, the &P 500 declined by 0.2%.
IBD: Confirmed uptrend
BCI: This site remains moderately bullish on the economy but is concerned about the upcoming earnings season given the severe weather conditions and shortened holiday season in the fourth quarter. As a result, I am tweeking my options sales to an equal number of in-the-money and out-of-the-money strikes.
Wishing you the best in investing,