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As we get to the end of July, we are entering the "heart" of the Q2 2020 earnings season, one of four such seasons we encounter on an annual basis. We typically find that earnings season produces some added volatility and potholes for investors to avoid. With earnings announcements happening almost daily in the coming weeks, many investors may wonder: "Am I going to hear any bad news from the companies that I own? And if the news is not good, how will my positions hold up?" Fortunately, if you'd rather not sit by and hope you are lucky enough to avoid any earnings disasters, you can consider buying some temporary insurance in the form of protective puts.
First, we'll review a few basics on puts, and then we will go over an example that typifies the successful use of the protective put strategy. Many investors have difficulty understanding puts when they are really quite simple. If you own a car, you likely own a put on it, provided that you carry collision insurance. A put is simply a contract giving the buyer the right, but not the obligation to sell stock at a certain price (the strike price) during a specified period of time. The underlying stock can be "put", i.e. sold to the writer of the put for the strike price, anytime between the time the option is purchased and the time it expires. Similarly, if you have an accident in your car, you have an insurance policy that states that the underwriter will pay you the cost of the damage. A put is basically the same thing -- you pay a premium to protect your stock; the only difference is that you are insuring against damage to the value of your stock rather than to your car. In either case, if an accident occurs, your losses are mitigated by the insurance you purchased.
Example of Using Protective Puts:
Now that we've discussed the basics of how puts work, let's look at an example of using protective puts to protect your portfolio during earnings season.
In the chart below, you can see that XYZ Stock broke out of a base on its Point and Figure chart at $244 and made it to a new high of $276 by the end of February. At that time, XYZ was moderately overbought at around 51% and was in a strong technical uptrend. By the time XYZ had reached its peak, the stock had a technical attribute rating of three out of a possible five and was gaining relative strength versus the market and its peers over the short-term.
During March and the first part of April, XYZ had a fairly significant pullback to $248. In April, the stock reversed back into a column of X’s just ahead of earnings season. By then, XYZ was a prime candidate for a protective put, as the stock was just below February highs and there was no material support on the default chart until just above the bullish support line. On April 30th, the day of Q1 earnings, XYZ May $250 puts could be purchased for $9.05. By doing this, you would have hedged against a possible bad earnings call and provided yourself with some peace of mind.
XYZ's Q1 earnings call took place after market close on April 30th. XYZ's stock opened at $252.13 the following morning, however, by the end of trading, the stock had declined by $53.73 (more than 21%) to close at $198.40. In just one day, XYZ's overall technical picture went from promising to an overall negative trend as it lost all three of its positive technical attributes. By the end of the day, the May $250 put was trading at $50.10, a gain of just over $41 as compared to the previous day's price. The $41 gained by the put would have notably mitigated the 21% drop in the stock's price. Ultimately, while most XYZ shareholders experienced large losses, those who purchased the $250 protective put would have suffered a net loss of only $12 per share compared to the over $50 per share loss for those who had no insurance. While this example may not be typical, it is not unique either; there is often significant and unpredictable volatility following earnings announcements.
An important characteristic of protective puts is that they do not cap your upside potential (as does selling calls against a position, for instance). Instead, if the stock you have hedged with puts continues to move higher going forward, you participate in the upside at all points and your returns are only diminished by the premium paid for the put.
Our example illustrates how protective puts can work to your benefit. But remember, protective puts are just like car insurance – no one appreciates having it until they need it. Just as you don't relish paying for car insurance, no one is excited about paying the premium for a protective put. But, just as with any other insurance, you pay a put premium not because you expect to have an accident, but because you know you'll be protected if you do. You have to ask yourself whether it is worth laying out the premium to have this insurance in place. If the answer is yes, then consider buying protective puts on stocks you may own. In the example above, we presented this strategy as a way to hedge against a negative earnings result in the very short-term. Of course, you can also buy longer-dated puts if you're seeking protection for a longer period of time.
Note: The example above is not fictional. This was the real experience of LinkedIn shareholders following the company's Q1 2015 earnings release. LinkedIn was acquired by Microsoft in June 2016.
A few points to remember when considering protective puts:
- Only buy 1 put for every 100 shares you own (or want to hedge). Don't over-leverage by buying more options than you need to protect your position.
- The protective put gives you insurance against a major pullback but doesn't cap your upside potential.
- Lastly, you may own stocks that are still technically sound overall: trading in an overall uptrend and at least a 3 for 5'er (or higher). But they may be extended, and a considerable distance above notable support. A protective put strategy is a good way to protect profits you may have built up in these positions in your portfolio.
For those interested, you can go to any number of sources to get a list of stocks due to report earnings in the coming weeks. With earnings season in full swing, there are many stocks that will be announcing earnings soon and are viable candidates for protective puts.
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