Options Opportunities Knock During Earnings Season

Even though second-quarter corporate earnings are expected to show one of the largest year-over-year increases in some time -- about 20%, according to Chuck Hill's recent article -- stocks have stumbled badly just as the reporting season is beginning to unfold. A flurry of unexpected warnings, mainly from tech firms, has undercut the recent trend of raised estimates, causing people to reconsider what now might be an overly optimistic outlook.

But the silver lining to the violent reaction seen in specific issues, such as the 25% decline in Veritas Software ( VRTS) or Wednesday night's schmiessing of Yahoo! ( YHOO), is that the simultaneous increase created in a broader volatility should offer a variety of trading and investment opportunities in the coming weeks.

Rather than making predictions regarding companies likely to provide earnings surprises, I'm using scheduled release dates to troll through a list of names that may be setting up for attractive risk/reward option positions. Below are five companies slated to report earnings in the next week, as well as suggested options strategies.

Note that the criteria used in selecting a strategy is based on current implied volatility, some technical analysis and broad macro trends where appropriate -- i.e., expected or actual earnings growth (or declines) don't enter into the equation. I'm not trying to game the response to the day of the earnings release, but instead I'm attempting to gain an edge based on the pricing of options in anticipation of the event. (I should disclose that I tend toward a contrarian view, meaning I favor buying stocks that are low and dropping, selling new highs, and expecting breakouts from flat trading ranges; those who like to see confirmations and momentum should click their mouse to another column now.)

The List, Please

Novellus Systems ( NVLS) is the first of the big chipmakers to officially reveal the state of the semiconductor industry when it reports on July 12. But it's already taken its knocks as expectations have been ratcheted down in the wake of recent warnings and lowered revenue guidance from names across the sector, including Intel ( INTC).

The recent selloff pushed the shares down toward the 52-week low and an important support level of $28.50. This area has successfully held and now provides an entry point for a good risk/reward trade. The implied volatility of Novellus options is currently running around 40, which is moderately higher than the 30-day historical volatility of 35 but near the midpoint of the midpoint of the 52-week high and low, offering no apparent edge.

A bullish call spread, in which you simultaneously buy and sell an equal number of call options, is one way to capitalize on any ensuing price gains while minimizing the impact of changes in volatility. With the stock set to report on July 12, I'd look to at least September to give this stock some time to get its sea legs back.

Tractor Supply ( TSCO) had been a real workhorse, gaining about 1,900% in the three-year period between 2001 and 2003. But the shares are down 10% for the year as its growth potential is moderating in terms of the number of new locations and demographic trends that the franchise can support. The stock certainly can work higher but the risk seems to have shifted, in that a quarterly earnings miss is likely to result in a big cut in market capitalization.

Its near-term options have been inching up in price, with implied volatility currently at 31%, which is higher than the 30-day historic level of 25%, but the implied volatility of the longer-term options are still near the 52-week low of 23%. One strategy might be to sell near-term calls and also buy longer-dated put options. Keep in mind this is an outright (doubly) bearish position, which can have unlimited risk.

With the stock currently trading around $40, I'd use a mental stop of $44 to cover the calls and I don't suggest rolling the short calls down if the shares decline. In other words, take the short-term profits on the calls and let the increasingly short delta of the put position run. The company is scheduled to report July 12.

Apple Computer's ( AAPL) recent news that it won't have enough inventory for the back-to-school season certainly takes some of the near-term starch out of the stock. But the company has always had its ups and downs, as the emotional connection of its fans and the skeptical perception of its growth potential by critics buffets the shares.

The shares remain pricey, but the company manages to survive and churns out popular and innovative products. An attractive play might be to sell put options. With these relatively high-priced options currently sporting an implied volatility of 44% vs. a 60-day historical volatility of just 26%, and good support at $28, selling puts is a way of accumulating shares or collecting some premium income. Apple will post earnings on July 14.

Marriott ( MAR) presents a fascinating situation. It has traded in a $1 range -- between $49.40 and $50.50 -- for the last four weeks. During this time, the implied volatility of its options has ratcheted higher and now stands at 30%, which is well above the actual 30-day volatility of 12% and just shy of the 52-week implied volatility of 32%.


Range-Bound
Marriott's shares haven't budged in a month

This presents a bit of a dilemma as the chart suggests that a move out of the current range is, if not imminent, certainly inevitable. However, the relatively rich option premium makes me reluctant to buy short-term options. Because Marriott is unlikely to break out of this range prior to its July 15 report date, which is one day before the July options expirations, you might establish calendar spreads in both puts and calls, i.e., sell a near-term or July strangle and buy a longer-dated September straddle. The former will help defer the cost of the latter, and following the earnings release, the stock might establish a new and sustainable trend.

Wachovia ( WB) has fallen 10% in the last month as concerns over integrating recent acquisitions and the impact of higher interest rates have weighed on the shares. The stock has good support at $44 and buying some LEAP calls might be an attractive way to add some limited risk exposure of the financial sector to your portfolio.

There are more than 200 companies releasing earnings in the next 10 trading days and then hundreds more over the next month; the above are just a few of the names that caught my attention. Consider this list and the accompanying strategies as a springboard for identifying the multitude of opportunities likely to present themselves in coming weeks.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to steve.smith@thestreet.com.

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