Fossil Earnings Trade and Process
- Posted by Greg Harmon
- on May 13th, 2014
Fossil, $FOSL reports earnings tonight after the close. What should you expect? Well there are 19 estimates of earnings on Estimize that expect a better report that the Wall Street analyst consensus of $1.19 per share on $773.74 million in revenues. That sounds great right, the unbiased crew likes it to do better. So are you a buyer or seller? Hmm, what does data that actually mean for the short run in the stock price? Is a beat priced in? Or is it priced to the Wall Street number? Too confusing for me. And since price is what pays you as a trader or investor I am only concerned with price and who other traders are pricing price. This is what I look at everyday. And why I use technical analysis to look for trades. Yes an earnings beat by Fossil can provide a catalyst for a move, but there are clues in the price record, like the history in the sediment layers of millions of years of rock in the Earth.
The chart above shows the price action for Fossil since the November high. Generally a downtrend with some sideways action from February to the end of March. But then the trend seemed to end with a consolidation period throughout April where it moved sideways. The blue envelope around the price is a measure of volatility and got very tight before the price moved back higher out of the consolidation. But it also moved outside of the envelope, an indication of an extreme move. These can correct back into the envelope through time or by price falling. The panel at the top is the Relative Strength Index (RSI) and it measures momentum in the stock. Over 50 is good and over 60 better. So it in a good spot but not a better spot. The panel at the bottom is the MACD, another momentum indicator, but without bounds. The blue line (important one) is rising which is a good thing, and crossed above the orange signal line (another good thing). I would say that the chart is pointing higher into earnings.
There is other information available on price too though. The options market offers a view of the expected price move by looking at the current month straddle. That is just lingo for the sum on the cost of both the at the money Put and Call. For Fossil I would use an average of the 11 and 112 strikes since it is in the middle of them. This gives an estimate of about a $8.15 move by expiration Friday. Or an envelope of 103.50 to 120. A pretty big range. There are other clues out there too. The biggest open interest is at the May 120 Call Strike and there is sizable open interest on the put side there too. These could draw the price higher by week’s end as holders trade to protect their positions. One other point: Short sellers have accumulated nearly 7% of the float in this stock. That is a decent sized bet that it will move lower over time. I could keep going, but the point is that there is a whole lot more information in the price record about where the price might go following the earnings report than based on solely knowing the content of the report.
So how do you deal with this? It seems pretty complex for Fossil, as the chart points higher but with a need for a short term correction through time or price. And the options also point higher. Do you just buy the stock and close your eyes? Of course not.
As traders and investors our first task is to manage risk. It would be reckless to just buy the stock. Unfortunately too many traders just stock right there and avoid a trade. The second task is to look for and set up good reward to risk trades. And with earnings as a catalyst and short term options this can be accomplished readily in most stocks. For Fossil I will first look at the possibility that a short term pullback may occur. We know from the above that options traders expect it will stay above 103.50, there is a support area at 106 and the bottom of that volatility envelope is at about 105. One way to design a trade for this is to look at a put ratio spread. A trader buying the May 110 Put and then selling the May 108 and 105 Puts would be paid a 40 cent credit for the May 110/108-105 1×2 Put Ratio Spread. What happens if the price rises? You keep the 40 cents. If it falls to between 108 and 105 then you would sell the May 110 Put and buy back the May 108 Put for $2 (or let your broker pay you for the Put Spread at expiry). The May 105 short put would then expire worthless. if the price falls below 105 then you are at risk of being put the stock (owning it with a cost of 105). Except that you still have $2 from the 110/108 Put Spread and the 40 cent credit for entering the trade, so your net cost for the stock is 102.60. That is below the envelope options traders are expecting, the volatility band and the consolidation zone. It gives me more comfort. Rises I win, falls I win, until it falls below 102.60. You should be prepared to short the stock below 105 to hedge this risk. This is how I look at earnings trades every day and so should you. I could go into the long side trade but I have already written nearly twice as many words as Josh told me I should write in a post…..
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Gregory W. Harmon CMT, CFA, has traded in the Securities markets since 1986. He has held senior positions including Head of Global Trading, Head of Product Development, Head of Strategy and Director of Equity. (More)
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