Never sell a covered call or cash-secured put option if there is an upcoming earnings report prior to contract expiration. I have been emphasizing this rule for over a decade in my books, DVDs, seminars and videos. There are times, however, when we have confidence in positive earnings reports based on historical data. In these rare cases, when we decide to hold the security through the report, we then write the call post-report. In this article, we will follow Broadcom, Ltd (AVGO) starting a few weeks prior to the report and then the day after the report is published (6/1/2017, after market close).
AVGO price chart on 5/26/2017
In the weeks leading up to the earnings release, the stock was in a trading range between $230.00 and $241.00. We are going to assume a purchase price at the mid-point ($235.50). Had we sold an out-of-the-money strike, a typical 1-month return would be between 2% – 3% with upside between 1-2%. We’ll again take the middle ground and assume a maximum 1-month return of 4%.
AVGO price chart on 6/2/2017, a day after the earnings release
A positive earnings surprise saw share price rise to $252.31 with 3 hours remaining until market close. Had we not sold the covered call, this would represent a share increase of 7.1% from purchase price ($16.81/$235.50). With 3 weeks remaining until expiration of the June contracts, we then check the option chain to see if we can generate a second income stream with an out-of-the-money call option.
AVGO options chain on 6/2/2017
The out-of-the-money $255.00 strike generates a premium of $2.65. Let’s feed this information into the multiple tab of the Ellman Calculator.
AVGO 3-week calculations post earnings report
The calculator displays an initial 3-week time value return of 1.1% with an additional possible 1.1% if share value moves up to the $255.00 strike by expiration. This now represents a potential maximum return of 9.3% (7.1% + 2.2%).
Comparison chart of AVGO and the S&P 500 leading up to the earnings release
Stocks that we might consider for this strategy approach are those that are out-performing the market significantly and have a history of positive earnings surprises. If we are willing to take the risk of a disappointing report, there must be a rationale for doing so.
We never sell a call or put option when there is an upcoming earnings release. We may decide to hold a stock through a report and then write the call if the underlying is out-performing the overall market and has a history of positive surprises. There is risk in a disappointing report even if past reports have been positive ones.
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Global stocks were flat on the week amid somewhat firmer interest rates and oil prices. West Texas Intermediate crude oil added $1 a barrel, trading at $51.50. Volatility, as measured by the Chicago Board Options Exchange Volatility Index (VIX), slipped to 9.51 from 10 a week ago. This week’s economic and international news of importance:
- President Trump unveiled a reform plan designed to simplify the US tax code. Seven tax brackets would shrink to three (with the potential for an additional bracket for high-earners) and the corporate tax rate would be cut from 35% to 20%. The plan would nearly double the standard deduction for most households and retain mortgage interest and charitable deductions while eliminating deductions for state and local taxes. The plan would end the estate tax and the alternative minimum tax
- German chancellor Angela Merkel will be forced to craft a three-party coalition after her Christian Democratic Union fared worse than expected in Sunday’s election
- Japanese prime minister Shinzo Abe dissolved parliament this week and called an election for October 22nd. Abe asked for a new mandate to deal with the growing threat from North Korea and said it is urgent that Japan’s social security system be rebalanced to cope with the growing number of retirees
- US Federal Reserve chair Janet Yellen this week said it would be imprudent to keep monetary policy on hold until inflation reaches the Fed’s 2% core personal consumption expenditures target, making a December rate hike more likely
- The US economy grew at an annual rate of 3.1%, a slight upward revision from last month’s 3% reading
- Corporate profits advanced at an annual rate of just 0.1% in Q2, a sign that the broad economy is performing worse than large multinational firms, which have recorded two straight quarters of double-digit profit growth
THE WEEK AHEAD
Mon, Oct 2nd
- Japan: Tankan survey
- Global manufacturing purchasing managers’ indicies
Tue, Oct 3rd
- US: motor vehicle sales
Wed, Oct 4th
- Global services PMI
- Eurozone: Retail sales
Thu, Oct 5th
- Eurozone” September European central Bank minutes
- US: Trade balance
Fri, Oct 6th
- Canada: Employment report September
- US: Employment report September
For the week, the S&P 500 rose by 0.68% for a year-to-date return of 12.53%
IBD: Market in confirmed uptrend
GMI: 6/6- Buy signal since market close of August 31, 2017
BCI: I am currently using an equal number of in-the-money and out-of-the-money strikes, taking a neutral overall portfolio position
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US
The 6-month charts point to a neutral to slightly bullish outlook. In the past six months, the S&P 500 was up 7% while the VIX (9.51) moved down by 17%.
Wishing you the best in investing,
Alan and the BCI team