Here’s a tutorial on how to trade options on a stock about to report earnings. And we then look at the set-up on Lowe’s ahead of its results this week. It’s understood that stocks tend to be more volatile when they report earnings. The perceived risk associated with that volatility may increase particularly if a stock has appreciated significantly ahead of earnings. Such was certainly the case with Nvidia which reported last week, and it’s probably not an exaggeration to say that the market breathed a large sigh of relief on their impressive results. In fact, the S & P 500 would likely not have achieved new highs without a positive response to Nvidia earnings. Earnings reports provide crucial information that can significantly affect the valuation and perception of a company. How a stock responds to earnings also provides clues to investor sentiment more generally. If good companies sell off on good news, that can be a sign that the momentum in the name, the group or even the market may, at least in the near-term, may be slowing. By contrast when companies whose operating performance and stock prices have been flagging manage to catch a bid, even after reporting less than stellar numbers, it’s possible they may be bottoming. Other than the trailing results it is important to also pay attention to: Guidance and Future Outlook: While not all do, many companies provide guidance or forecasts about future performance in their earnings reports or during the earnings calls. This guidance can significantly impact investor expectations and the stock’s valuation. Upward revisions in guidance can lead to positive market reactions, while downward revisions can have the opposite effect. Sector and Industry: It’s common monitor stock market performance by sector day to day, but when looking at earnings personally I prefer to narrow my focus to an industry or even sub-industry as sectors may be overly broad when examining individual results. Competitive Positioning: The earnings report can provide insights into how well a company is performing relative to its competitors. By analyzing the reports of companies within the same industry, investors can gauge market share shifts, competitive advantages, or weaknesses as well as economic trends affecting the group. Lowe’s this week Consider Lowe’s which is scheduled to report earnings on Tuesday. Its better known, and in some cases better operated, competitor Home Depot has already reported. Home Depot reported about a 14% decline in EPS and revenue fell by more than $1 billion for the quarter versus the prior year. It’s not difficult to figure out why the home improvement giant’s operating results aren’t keeping pace with the economy more broadly. Existing home sales: Higher mortgage rates mean lower existing home sales. Higher rates make a home less affordable. For owners who might otherwise have considered a move, some homeowners become “trapped” in their homes if their existing mortgage is at a favorable rate. Many homeowners enjoy interest rates below 4% on their existing mortgages, whereas the rate offered on a new 30 year fixed mortgage is closer to 7.3%. Moving houses becomes far less appealing if it also means moving from a historically low rate, to a much higher one. A lot of home improvement projects stem from fixing up a home for sale, or improving one recently purchased. Pull forward: Even ignoring home improvement projects related to home sales, many homeowners were forced to stay home during the Covid pandemic, and many continued to work from home at greater rates than before. This spurred a lot of improvement projects. Much of the big revenue increases the home improvement retailers saw was a short-term phenomenon and this chart reveals just how substantial and unusual the associated revenue growth for the home improvement retailers was when we compare it to the economy more broadly. Despite the unremarkable results Home Depot reported, after initially falling about 2% from Friday’s close to Tuesday’s open, the stock has since rebounded. HD 1M mountain Home Depot, 1 month Competitor Lowe’s, which we also own, has followed suit. LOW 1M mountain Lowe’s, 1 month That both outperformed the S & P 500 recently suggests that investors may finally be looking past current operating results and are instead getting more optimistic about what the future may hold. Consensus projections for Lowe’s are unambitious at the moment. Unsurprising given the company’s own guidance suggests same store sales could decline 5%. The consensus revenue estimate of $86.16 billion for the full year ending January 2024 modestly exceeds the company’s $86 billion guidance, but would represent an 11% year-over-year decline, significantly greater than the annual revenue decrease Home Depot just reported over the same period. But as the following scatterplot of quarterly revenue changes reveals that correlation does come with a fairly wide potential spread from one quarter to another. Lowe’s puts? How risky is it to buy (or sell) Lowe’s into earnings, and if it is risky, do options offer an opportunity to reduce the risk at a reasonable cost? To understand this let’s take a look at volatile Lowe’s has been around earnings historically. The bars on this price chart reflect the move in the stock price from 1 day prior to earnings to 3 days following earnings, which provides more than the knee jerk reaction which follows the release and allows investors some time to digest the results. As the bars show, declines of greater than 5% are in frequent, and at least one of those large declines, in early 2020, corresponds with the pandemic plunge in the markets generally. An “at the money” put that expires at week’s end, in this case the weekly 232.5 put, costs just under 2% of the current stock price. It turns out that 21 times out of the past 44 reported quarters, or nearly half the time, Lowe’s fell by 2% or more over a similar time frame as that option’s expiration covers. Put differently, history would suggest that buying that put would have yielded positive returns overall. Might a lower strike, and therefore lower cost put also have utility? The answer, because options premiums generally aren’t high in Lowe’s right now, turns out to be yes. For example one could pay roughly 1/10th as much in premium, or just over .2% for the 217.5 puts, which are nearly 6.5% out of the money. The chances that this insurance pays off are substantially lower, because as the chart shows, moves of 6.5% or more to the downside were quite infrequent occurring only 5 times over the past 11 years. However the payout when they did kick in proved sufficient that they would have justified their premium overall. Here are tables of how puts of various moneyness would have performed historically assuming they were available at today’s prices. Unsurprisingly if puts are reasonably priced, calls appear to be as well. Notice that in both cases as one gets farther and farther away from the current spot price, the expected returns of the options declines even though the premiums may be considerably less. The reason is, in Lowe’s at least, moves of those magnitudes the week of earnings are quite infrequent. As a final aside, I offer this chart for your consideration. If you’re waiting for a rebound in revenue growth relative to economic growth for either Home Depot or Lowe’s, we likely need to see a rebound in home affordability, and that will need a decline in home prices, mortgage rates, or both. DISCLOSURES: Khouw owns Home Depot and Lowe’s shares. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
