Oracle's Going Down: How to Trade Earnings
All eyes will be on Oracle's third-quarter results after the close on Wednesday, March 20. Its results may be market-moving. The company has a history of beating estimates, which now range from 65 cents to 70 cents a share.
Simply beating the average estimate of 66 cents per share will not be enough to propel the shares higher, but a beat of at least 4 cents will surely move the needle.
We don't predict the future; we predict the odds. Chances are, within days after a beat, Oracle's shares will tank. An upward path throughout 2013 should eventually follow. In the interim, there is money to be made.
I believe Oracle will report near the high end of the range or slightly beat. More importantly, Oracle appears well positioned to offer surprisingly high guidance. Granted, it's been a long time since we have had a mindset of economic growth, but history has clearly demonstrated that economic growth cycles always follow periods of contraction.
One of the world's leading suppliers of software for information management, Oracle trades an average of 19 million shares per day with a market cap of $171 billion. Since September 2012, Oracle's value has grown an impressive $13 billion.
Let's look under the hood and see if you will agree that the numbers support Oracle as an attractive investment.
Nothing paints a picture quite the same as per-share data. It's easy to get your head wrapped around a company's performance as it relates to each of your shares.
Oracle is best in class for earnings per share growth. HP basically fell off the map but may turn the ship around. Can HP climb back to the glory days of $40 per share or more? Don't count on it this year, although 2013 appears bullish, even for HP.
What many may find striking is Oracle's move above Apple's EPS growth rate. I included the metric to illustrate how much pricing power Oracle has. When it comes to database vendor investments, Oracle is best in class. There is little reason to expect its current status to change anytime soon.
Next, free cash flow comparisons allow investors to see what a dollar investment can expect to yield in overall profitability. Free cash flow return for Oracle, Red Hat, IBM, and Microsoft illustrate how well Oracle has navigated the space. It moves with a steady and stable hand. The market hates uncertainty; one look at Apple's stock chart shows how uncertainty is punished.
Oracle doesn't pay a large dividend like many of its peers. That's likely the result of Oracle's stock remaining resilient while others haven't.
If we all agree that Oracle is expected to crush the earnings report, how can we profit? The simplest way is obviously to buy shares. There is another strategy that I like better for the risk-averse.
Oracle is so heavily traded that option contracts are very liquid. This is especially so near an earnings release. The problem most options investors have is that they view options plays the same way as the underlying stock.
Most investors will buy a call if they believe the earnings will be good, and buy a put if they believe (or are concerned that) the stock will fall. Sounds simple enough, until you factor in what is known as implied volatility. Implied volatility is the devil that makes options relatively expensive before the earnings release, and cheap afterward.
You can be correct on the movement of the stock and still lose money buying options. A superior method, in my opinion, is a strategy that includes a spread. While the possibilities are nearly endless, one of the most simplistic options spreads is buying one strike price and selling another.
Before we venture into which spreads may offer the best risk-to-reward opportunity, it's helpful to examine the impact previous earnings releases have had on shares.
After the Sept. 20, 2012, release, shares moved from $32.26 to a next-day high of $33.29, before closing slightly higher at $32.47. If you timed a sale the day after earnings, you likely did very well. However, that day after was followed by three down days.
Investors buying call options before the release, and who were fortunate enough to sell at or near the top, did marginally well. All other call buyers had their heads handed to them, especially if they didn't exit the following day. Put buyers didn't fare much better because of time-premium (implied volatility) evaporation, following the release.
The Dec. 18 earnings release shares much in common with the September release, $2 higher at the peak, followed by six days of lower closes. A straight call option purchase may have resulted in a respectable gain if closed out near the high of the day, but again, how do you know when the high is upon us? The simple answer is, you most likely don't, and that leaves much to chance.
Feel free to review more earnings releases, and you will notice the pattern of strength followed by weakness through 2012. Again, we don't predict the future, we predict the odds. With that in mind, if Oracle beats the estimates, as I expect they will, we should see the stock gap higher, followed by weakness in the days proceeding, as I mentioned earlier.
To take advantage of the relatively high option premium in front of earnings with a bullish bias, we can sell a bull credit spread. A bull credit spread uses two put options, with the higher strike price sold, and the lower strike price bought as a hedge.
We are able to control our risk to the amount between the two strike prices, while at the same time put the odds in our favor as a result of premium decay.
A bullish credit spread I like is the March 22 weekly expiration $36 and $34 strike prices. This includes selling the $36 strike put for about 57 cents and hedging with a $34 strike for about 13 cents. The net result is a credit of 44 cents per contract. The downside risk is $1.56 ($2 difference between strikes, less the premium received).
If you want to learn more about options and the math used to calculate what your ideal strategy should include, pick up a copy of "Options Math for Traders," by Scott Nations, published by Wiley Trading. It's a must read for anyone who is serious about learning the fine details of selecting the correct options strategy based on your objectives.
After the earnings release, look to close out the position not long before noon. As an active options trader, it's my experience that the best time to sell options is near the open and close of trading, and on average, the best time to buy is during the lulls of midday.
Taking Oracle one step further for investors, you may want to consider buying protective puts outright after the earnings release with an expectation of selling two or three days later. Once the dust settles, and if nothing changes, expect Oracle's stock to continue the upward path throughout 2013.
—By TheStreet.com Contributor Robert Weinstein
At the time of publication, the author held no positions in any of the stocks mentioned, although positions may change at any time.