This is the best strategy after earnings disappoint

Time for another out of the money call credit spread.

When Best Buy Co. (BBY | Quote | Chart | News | PowerRating) missed its second quarter earnings target Tuesday, and downgraded its forecast for third quarter earnings, the nation’s largest consumer electronics retail company took a licking.

This kind of news can often keep the bulls at bay for at least one full quarter until earnings results are announced again, offering up a reliable setup for an out of the money call credit spread.

Figure 1 shows the large gap lower on Tuesday, 9/13/05. The big drop was followed by a small gain on Wednesday, leaving the stock at 44.79, 10.9% below the pre-gap close price.

Figure 1 – Generated using OptionVue 5 Options Analysis Software

As I’ve written in previous articles, I like to sell a call near the pre-gap close (preferably a little higher) because this will provide good resistance should the stock price attempt to climb back because investors who did not get a chance to sell will most likely sell into rallies back into the gap.

Therefore, I will sell a December 50 call for $115 and cover it with a December 55 long call for $40. This will give me a net credit of $75 for each spread I put on, with a maximum risk per spread of $425 (the size of the spread minus premium collected) if the position suffers from a price move back above the short strike (Dec. 50) and all the way to the long strike (Dec. 55). If the stock remains below 50 by expiration on December 17, this trade makes 17.65% profit.

But we will use a doubling of the credit as a mental stop loss for closing the trade, or if the price of BBY touches the short strike, we will close the trade. This keeps losses manageable.

Figure 2 shows the profit/loss parameters for this trade, with breakeven at 50.75, just above the pre-gap close price of 50.36.

Figure 2 – Generated using OptionVue 5 Options Analysis Software

If you do these kinds of trades, be sure to risk no more than 3-5% of your trading capital per trade. And it is always good to have both bullish and bearish trades in your portfolio of positions to balance out the beta risk.

Finally, it sometimes pays off to wait for a one day bounce before putting on the spread just to provide an additional edge to the position.

Good luck with your trading!

John Summa, CTA

John F. Summa is Founder and President of OptionsNerd.com, and a registered Commodity Trading Advisor (CTA) with the National Futures Association (NFA). Founded in 1998, OptionsNerd.com offers trading seminars and tutorials to options traders, futures and option trading advisories and managed futures and options CTA account services. Mr Summa's trading articles have appeared in Technical Analysis of Stocks & Commodities magazine, as well as Active Trader Magazine, Options Trader Magazine, Futures Magazine, Stock, Futures & Options Magazine, and Investopedia.com. He coauthored Options on Futures: New Trading Strategies and Options on Futures Workbook (John Wiley & Sons, 2001) and more recently wrote the groundbreaking book, Trading Against The Crowd: Profiting From Fear and Greed in Stock, Futures and Options Markets (John Wiley & Sons, 2004), which includes Mr. Summa's innovative quantitative bear and bull news-flow Contrarian indicator. Mr. Summa is a PhD-trained economist and operates a delta-neutral options trading CTA program.

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