Aleksander Danilov sent me this note last night. I assume he was asking for a friend. I look at a lot of stocks for a potential trade around the earnings event. But Twitter (NYSE:TWTR) would not qualify for me. There is not enough earnings history with only one report. So I will not be reviewing it for subscribers.
But Aleks’ question is from a different perspective. What would the long holder do with earnings coming up. This turns the analysis from one focused on potentially extracting a large value with very little downside risk, to one of protection of an existing position. No longer is this a speculative trade to augment a portfolio but a play to protect the current investment and allow for additional upward price participation. This is a question that all investors should be asking around earnings events for every stock, or at least the most volatile ones, in their portfolio. Let’s take a look:
The chart above shows the brief price history of TWTR, as a public company. You can see that it had a quick rise to the high at $75 and then a has been in a slow steady burn lower. Elevator up, stairs down—but wait isn’t that backwards?
The move lower found an initial bounce at the prior low base from November before bouncing. But it looks like a Dead Cat Bounce (if you have never heard that before think about how high a dead cat would bounce) and it is now back at those lows into earnings. The momentum indicators, RSI and MACD, are both pointing lower, supporting more downside. The chart does not look good into earnings.
The options market shows that the stock has weekly options expiring on Friday and they are pricing a 14% move or $5.80 on an At The Money Straddle. That is a range of about 34.50 to 46.50. With no support under 38 or so the downside looks a bit scary. The Open Interest is pretty large at the weekly 40 Strike Put and that may keep it from falling too far, but also at every Strike from 35 to 31 below. There is also large Open Interest on the Call side at the 45 Strike. Short interest is high at 14% as well, so an upside surprise reaction could trigger a short covering ad push the stock higher.
So how do you protect this? One way is with a collar. You want to protect the downside and expect the bulk of an move to happen as a result of the earnings event. With the large Open Interest below you want to participate dollar for dollar in any move lower. You can do this by buying Puts or a Put Spread. If you were to buy a May 2 Expiry 40/34 Put Spread for each 100 shares owned that would cost a little over $2 at Monday’s closing levels. This protects you on a move lower to 34. If that is not enough for you then just buying the May 2 Expiry 40 Puts gives unlimited downside protection for about $2.65. The cost of protection is 5-7%. That is a lot. The collar then looks to sell a Covered Call to reduce that cost. In this case selling the June 6 Expiry 46 Call gets back $1.75 of that cost. This allows you to continue to participate in the upward price action until 46, or 13% higher, and reduces the cost of protection to either 25 cents or 90 cents, or 0.6-2.2% of the price of the stock. A 2% cost to be able to continue in the trade for a possible 13% gain seems like a good reward to risk ratio.
Come back Tuesday, after the print, and we will see how to adjust this plan.
Disclosure: The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.