Okay, so let’s say you’re holding a big share position in a particular company, but you’re facing a dilemma.
For one, you’re not comfortable because of the way the market is acting. And second, you’re not sure how recent news may affect the company’s forward guidance.
As if that isn’t enough, few events can influence the short-term direction of share prices like earnings season…
That’s the situation that faced many Visa, Inc. (NYSE: V, Stock Forum) shareholders a few weeks ago.
Let me show you how you can handle the earnings season conundrum…
Not Cash or Charge… Cash and Charge
A few weeks ago, Visa’s debit card business was in the government crosshairs. Specifically, the government was concerned that Visa was charging merchants too much for debit card processing.
Debit cards are like cash and Visa charges merchants a percentage of the transaction total on every debit payment it processes.
Visa hands the card’s issuing bank a big chunk of that transaction fee. And the retailer passes the fee on to the consumer as part of the product price.
In effect, you’re being charged for the convenience of using your own money.
So that’s the scenario…
Visa’s business was under the threat of government regulation just weeks before the company released earnings. And shareholders were sitting right in the crossfire.
The Only Time to Use Short-Term Options
When the legislation passed, Visa shares took a hit, but not a big one.
But the issue for shareholders was this: What would Visa say about its future earnings as a result of the new legislation? Would it guide lower? Would the news be priced in? Would the stock tank once investors heard the news?
Keep in mind that it would be nearly impossible for 99% of investors to figure out the impact of something like this without having direct knowledge of Visa’s fee structure or internal calculations.
So what would you have done?
To handle an unpredictable situation like this, it’s the only time that I advocate using short-term call options. But only with certain assumptions. For example…
- You can only use this strategy within days of the earnings release.
- You might give up a few percentage points worth of potential gains on your shares if the share price might move higher.
- You’re not expecting a catastrophic share price collapse, but with the price likely to move lower, you’ll protect your downside.
A Safety Net Trade with Short-Term Call Options
So in reality, here’s your safety net trade (please note that this is not a specific trade recommendation, just an example of how this strategy works)…
A couple of days before Visa issued its earnings, the share price was trading at US$75. The downside wasn’t likely to be more than 10% to 20%. And the upside was also fairly limited, since the news wouldn’t be perceived as “great.”
- Look at the options with a strike price about 20% below the trading price. In this case, the closest would be the $65 call options.
- Sell the August $65 calls, trading at $10.50 against your share position. In doing so, you’d receive $10.50 per share, thus reducing your cost to $64.50 ($75 minus $10.50).
- Your upside would be limited to $75.50 ($65 strike price plus the $10.50 premium received).
If Visa shares moved lower: You’d be covered since the options premium received would offset the decline in share price.
If Visa shares moved higher: You’d be obligated to sell the shares at $75.
In this case, Visa dropped by $3, so you’d have lost nothing. You could simply buy back the option and maintain control of the shares.
When you have a lot of money at risk, it’s prudent to do more than just “hope” that things will work out fine. And with options, you can do just that.