Never sell a covered call or a cash-secured put if there is an upcoming earnings report. I will continue to repeat this mandate to ensure that new members will not suffer the financial fallout from a disappointing earnings report. There are times, however, when we have so much confidence in a stock which has historically beaten consensus estimates, we may want to keep the stock through the earnings report rather than sell it. This article addresses how we can achieve this goal and provide protection if the report disappoints.
What is a protective put?
This is an option that defends against a decrease in share value of a security already owned. It gives the put holder the right, but not the obligation, to sell the stock at the strike price. As it relates to earnings reports, protective puts would need to be purchased four times a year for a stock remaining in a covered call portfolio.
Real life example
I am writing this article on 4/22/2016. Let’s have a look at the price chart for Proto Labs Inc. (PRLB):
Since the beginning of February, this stock has been on a nice run-up and made our Premium Watch List. The projected earnings report date is 4/28/2016. We know that we cannot write a covered call for the May contracts at this time but would like to hold this security through the earnings report and then sell the call option.
Options chain for PRLB
Two strikes commonly considered in this scenario are the $75.00 put which costs $1.60 and the $80.00 put which costs $3.30. The more protection we have, the more costly is the protective put.
Stock stop loss orders versus protective puts
Limit orders have the benefit of not costing us any cash but the disadvantage of not having a defined specific maximum loss as do protective puts. Many investors will set limit orders at 8-10% below the current price so that would calculate to approximately $75.00 for PRLB currently priced at $81.50. If the stop loss order is hit and shares sold at $75.00, the loss is $6.50. However, if the price gaps down after a disappointing earnings reports, the loss can be more than $6.50, sometimes significantly more.
Calculating maximum losses with protective puts post-report (price decline to strike + cost of put)
$75.00 put: $6.50 + $1.60 = $8.10
$80.00 put: $1.50 + $3.30 = $4.80
If share price declines below the strike, there is a benefit to the higher strike protective put.
Actions to take
- Puts can be sold at a (likely) profit since share price moved down and then a covered call written on the devalued equity
- Put is exercised at the strike price and the cash used to purchase a different stock for a covered call trade
What if share price stays the same or moves up in value after the report?
In these scenarios, the insurance of protective puts was not activated. Put value will decrease for three reasons:
- Theta is eroding the time value component of the put options
- As share price rises, put value declines (Delta effect)
- The implied volatility of the security will decrease substantially after the report
Actions to take
- Sell the put option at a (likely) loss getting as much remaining premium as possible
- Write a covered call on the appreciated security
Stocks with Weeklys
If the underlying has Weeklys associated with them, puts need to be purchased for only the week of the report which will cost much less than the monthly put.
It is critical to avoid earnings reports when selling options because of the inherent risk from a disappointing report. Should an investor hold a stock through the report with the intent to write a call after a favorable report, consideration should be given to protective puts. The benefit is defined protection against catastrophic loss and the disadvantage is the cost of the put. In many cases, the maximum loss is less than that of setting a no-cost stop loss order.
Upcoming live events
September 10th, 2016
Silicon Valley (San Francisco) California
8:30 AM – 12 PM
I am the 2nd of 2 speakers
Registration link to follow
October 24th, 2016
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November 5, 2016
Plainview, New York
Saturday morning 3-hour workshop at the Plainview Holiday Inn. I am the only speaker and plan an information-packed presentation covering 5 actionable ways to make money or buy a stock at a discount using both call and put options. I’ll provide registration information once I receive it from the host investment club.
New spreadsheet available in Premium Member site
This amazing tool, developed by Premium Member David L, allows us to evaluate current covered call positions mid-contract and offers several “what-if” scenarios. Login to the member site and scroll down the “Resources/downloads” column to “D”. There is also a user guide written by Alan to explain all 32 cells.
Global stocks dropped slightly this week. The Chicago Board Options Exchange Volatility Index (VIX) declined slightly from 11.87 to 11.36. This week’s reports and international news of importance:
- The monthly increase in nonfarm payrolls for July came in at 255,000, above the consensus 180,000. This positive news arrived after a healthy 292,000 in June and a very poor 24,000 in May
- The unemployment rate remained at 4.9%. This news increased the chances of interest rate hikes in 2016
- William Dudley, vice chairman of the US Federal Reserve’s Federal Open Market Committee, said Monday that although there are lingering risks to the US economy (Brexit and a strong dollar), a rate hike can’t be ruled out for the rest of 2016
- The US ISM manufacturing purchasing managers’ index, a measure of economic activity, declined to 52.6 in July from 53.2 in June
- US President Barack Obama again stated his support for the Trans-Pacific Partnership (TPP) trade agreement this week, despite weakening support in Congress and opposition from presidential candidates Hillary Clinton and Donald Trump
- With just 66% of the S&P 500 Index having reported, adjusted earnings are down 2.6% from the same period a year ago. This represents the fourth straight year-over-year decline
- Second quarter earnings are expected to rise 1.8%, while revenues are expected to rise 2.8%.
- The Caixin China Manufacturing PMI came in at 50.6 — above 50 for the first time since February 2015
- The July Markit Eurozone PMI declined to 52, which still looks positive. However, concerns over Brexit remain for investors looking forward to 2017
- The United Kingdom PMI fell from 52.3 in June to 48.2 in July
- European banking shares have struggled year to date as the MSCI Europe Bank Index has declined about 26
- The Japanese yen has strengthened significantly versus the US dollar in
THE WEEK AHEAD
- The second quarter change in unit labor costs is reported on Tuesday, August 9th
- The US Bureau of Labor Statistics JOLTS result is announced on Wednesday, August 10th
- The Reuters/University of Michigan Sentiment Index is released on Friday, August 12th
For the week, the S&P 500 moved up by 0.41% for a year-to-date return of +6.79%.
IBD: Market in confirmed uptrend
GMI: 6/6- Buy signal since market close of July 1, 2016
BCI: Moderately bullish favoring out-of-the-money strikes 2-to-1
WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US