Should You Trade Covered Calls During Earnings?

It is an exaggeration that you should avoid all stocks posting earnings before expiration of your short call. Here are the factors to consider if you intend to write a stock across earnings:

  1. Does the company consistently grow earnings?

The roster of great companies consistently growing earnings per share changes from time to time, but these are the ones to choose if you will write across earnings. Management of great companies find a way to make a profit, period. Management tends to foresee trouble coming and plan for it. For example in mid-2008, Tiffany reported excellent earnings growth, principally driven by expansion into Asia. They foresaw declining revenues in the large Western markets and moved aggressively into developing markets, which smoothed and added to earnings. This is the kind of prescience we expect in first-rate management. Being part of this elite list is no talisman, but it’s the best bet. If the company you are writing across earnings does not belong to this club, can you do better?

  1. What is the size and quality of the company?

Large companies have diverse operations, and one faltering segment or division will have less effect on earnings; though if all are faltering, earnings will suffer. I used to believe that the larger the company, the less likely it is to sell off heavily, unless heavily overvalued to start with. After all, such a company usually pays a decent dividend and they tend to be “defensive” stocks that people own for their very size and quality. But giant companies faltered in 2008 and so far in 2009. General Electric fell below $10 in 2009, proving that the bigger they come, the harder they can fall. Let’s face it: if GE can sell off, any company can. Conversely, the smaller the company and the more concentrated its business in one or a few lines, the more dangerous it should be considered.

  1. Is the stock overvalued?

Every stock has a price-to-earnings (PE) ratio; this is the ratio of the stock price to earnings per share. If the stock price is $10 and earnings are $1.25 per share, then the PE ratio is 8:1. PE ratios also are calculated for industry groups, for sectors and for indices. The S&P 500’s PE ratio is the one almost universally used for comparison purposes. A stock with a PE ratio higher than that of its industry is said to be overvalued. In fact, the industry group’s PE ratio itself might be overvalued compared to the S&P 500. The more overvalued the stock is compared to its industry and the market, the farther it has to fall.

The market does not care that much in the abstract about valuation “fairness,” which is why we have fad stocks in the first place. But the market very much cares when reported results or other news makes the illusions about the company or its industry impossible to propagate any more. Stocks that fly too close to the sun (greatly overvalued) will fall sooner or later. What often happens is that a bellwether stock in the industry stumbles, taking the smaller stocks with it. The sell-off can be breathtaking. That may not happen while you have a covered call position on in the stock, but the overvalued company does not have to stumble – it merely has to issue negative or “cooling-off” guidance. Then it can really retreat.

  1. Has the stock run up on earnings anticipation?

This usually is evidenced by a preannouncement increase in price that is not attributable to other factors. The more the stock price has run up, the more likely it is to sell off as traders who bought the rumor then sell the news, because as noted above, most of the buyers are already into the stock by the report date. Often the sell-off is limited and temporary – see No. 6 below. Still, a few excellent companies with strong earnings and earnings growth will rise on a good report, despite the run-up in price already, because it is a company people want to own.

  1. How are earnings in the industry group?

If the company’s industry is struggling (e.g., airline companies hit by surges in fuel prices), then you can reasonably expect a mediocre or poor earnings report. If you select a strong stock in a generally struggling industry, expectations will, unofficially, be somewhat lower for the stock you write. On the other hand, there is a significant risk that the problems weighing on the industry will at some point get their claws into the company. I suspect that the market is quicker to cut and run when a good company in a faltering industry shows signs that the industry malaise is catching up with it. For one thing, institutional hands have a hard time explaining why they didn’t avoid the stock or get out sooner.

The ideal is a strong industry, strong stock. If the industry is healthy, it augurs well for the company itself. A healthy industry will not much protect an individual laggard, though. Note that problems in one industry can affect another; when computer makers stumble, for example, chip makers are affected by the lower demand. If unfamiliar with an industry (or its co-dependent industry groups), be leery of writing the stock through earnings.

  1. What is the company’s history of earnings reactions?

Though certainly no guarantee, the best predictor of a company’s reaction to earnings (assuming no bad report or negative future guidance) is its reaction to past earnings reports. Granted, the stock could have had weaker earnings or prospects in a prior period that would account for historical earnings sell-offs, and stronger recent earnings might lessen the danger. Look for consistency, if there is any. Some stocks have a tendency to sell off briefly then snap back, so long as their prospects are not materially changed. But in that event, why not wait until the stock has sold off and buy the recovery?

  1. Is the company unprofitable?

Unprofitable companies, and those without revenues, trade at a forward PE, which really is an estimated future PE. If the earnings report or future guidance makes the forward PE untenable, the company is likely to sell off. Don’t assume just because a company has been losing money for a while that the earnings report is irrelevant. Not meeting the consensus number can hurt even such a company.

The “safest” money-losers to write are the really large, household-name companies wandering in the earnings wilderness and expected to get back into the black at some point. The sell-off risk is reduced when, and only if, the company already has substantially sold off. There is a risk of continuing price deterioration, obviously, and the stock price should have stabilized in a new price range. This is not a very conservative write, but also not very dangerous generally, because the company already has been spanked and the Street is not expecting much, either way.

  1. What is the state of the economy and market?

As we learned from October 2007 through April 2009 (as I write this), even the best companies sell off mightily in a bear market. We have also seen that no matter how much a stock has been spanked, continuing deterioration in earnings or future guidance can keep it tumbling right on down. In troubled economic times there is no tolerance for any stumble. Writing a stock across earnings in such an environment is taking a real chance.

  1. Has the company preannounced?

Earnings preannouncements are not required by law. Failing to preannounce is not a bad thing, therefore, and many companies as a matter of policy do not do so. If the preannouncement was negative, the stock should be declining and we know to avoid it, anyway. If the company has preannounced positively, then there is less likely to be a negative earnings surprise or negative future guidance. If earnings are worse than the company guided in the preannouncement, however, look out. This doesn’t happen often, luckily; but it does happen.

Sometimes those who write across earnings also buy a cheap long-term put (very low time value) to protect the stock when it is held through the earnings report or other event, just in case of a sell-off – especially if negative guidance is given. An OTM or ATM put strike normally is chosen. The put’s low implied volatility, low delta and low theta mean that it will not be much affected by passage of a few days or weeks, nor will it be much affected – generally – by the event announcement.

If the stock does sell off, the theory goes, the writer can exercise the put to dump the stock, or sell the now-more-valuable put and keep the stock. However, the put always will have time value, unless well ITM. There are other concerns with this hedge, also:

  1. If the stock rises, the put’s value will be reduced, yet the call writer can expect to be called out at the call’s strike price. The un-recouped put cost (put cost – call premium) will offset the return from the covered call side of the trade, possibly turning a great trade into a loss.
  2. If the stock sells off, the put will provide protection, but a loss still will be realized, to the tune of the un-recouped put cost. And if we are writing the kinds of great companies that we should be, is the put cost worth it or are we better off to avoid companies reporting?

The Earnings Wrap-Up

No matter how carefully planned, a write across the earnings report can result in a damaged stock. As noted, an excellent company in good or at least not-terrible economic times (absent lousy earnings or lousy future guidance) may pull back but the pullback should be minor and be recovered in a few weeks. We can distill our lore for writing across earnings to these:

  1. The company should be E.D – consistently growing earnings, revenues and dividends.
  2. We want to see positive guidance, not silence. Double points for positive future guidance, although this not as common in preannouncements.
  3. The company’s industry group is not struggling, nor is a bellwether stock in the industry (e.g., Intel in semiconductors).
  4. If price already has risen on earnings anticipation, pass unless there are at least two weeks remaining until the report – buy before the stock is fully bloated.