Jabil Circuit: Options Strategy Ahead of Earnings

Jabil Circuit (JBL) is expected to report earnings the week of June 23rd, 2009. Looking forward to earnings, I don't have an opinion, but based on my long-term favorable view of the company's prospects and past behavior around earnings, an option strategy seems attractive – a reverse collar or fence, something that has worked on this stock in the past.

At Expiration - Looking toward expiration, if the stock finishes between 5.00 and 10.00, both sides expire worthless and the investor/speculator gets to keep the credit received. If the stock finishes under 5.00, the puts will be assigned, resulting in the ownership of 1,000 shares at an average cost of 4.90. If the stock finishes over 10.00 (unlikely) large profits will follow.

Interim Values - If on 7/1, after earnings have been reported, the stock has increased to 8.00 (as a hypothetical example), the position would have the following value, per an options calculator on CBOE:

The main attraction here is, after opening the position for a net credit, if somewhere within the next two weeks the share price increases, it can be closed for a quick profit. Checking a chart for the past three months the stock has been as high as 9.14, so this position does not require it to reach new highs in order to show a profit.

Why Jabil? - I wrote the stock up favorably on March 25, 2009, when it had recently traded at 6.63. The downside is fairly well defined by the tangible book value, 6.46 per share as of 2Q 09, which serves as margin of security. The stock got down under 4.00 during the worst of the meltdown.

The upside is very indistinct; however, based on a Price/Sales analysis, a share price of 30 seems possible. Options pricing models don't make an allowance for these types of value distributions and if a sufficient number of bets of this type are made the occasional long shot coming in will make the strategy profitable.

Jabil CEO Tim Main presents well: if he has any kind of good news he may go into cheerleader mode, leading to a quick pop.

Earnings Surprises – According to David Dreman, stocks which have low expectations do not react much to negative earnings surprises. On the other hand, they respond very well to positive surprises.

Characterizing JBL as a low expectation situation, the likely outcomes are that the stock will either stay pretty much where it is if earnings are as expected or less, or jump higher if earnings are favorable.

Risk/Reward – The downside manageable, the investor could wind up buying 1,000 shares at less than the tangible book value per share. The rewards vary depending on the trajectory of share prices between now and earnings or expiration, but will be attractive compared to the low out of pocket cost in the event of a favorable earnings surprise or if the stock performs better than the market expects.

I recently did a study of my options trading from January 1, 2007 to May 31, 2009, and overall results for positions of this type were very profitable, perhaps because we have been in a period of time where better results are achieved by asymmetrical risk/reward profiles.

Disclosure: Long JBL, including an options position similar to that described.

Comments

[TCK:]

What are your trading costs ?

Seems like commissions would make this strategy's risk/reward substantially different for a retail investor.

Jun 19 05:39 AM

[Tom Armistead:]

Trading costs for a retail investor (which I am) would be somewhere between 15 and 27.45 to trade 10 contracts, depending on the broker.

Also not discussed in the article would be slippage - when making trades to exit the position there can be nickels and dimes on the bid/ask which adds up.

Finally, it should be noted that the puts have to be backed by cash, so somewhere between 1,500 and 5,000 has to be available while the position is open, in the example given. Calculations of return on investment need to include these sums at risk.

Options pricing assumes that the current share price is correct and that increases or decreases are more or less randomly distributed. This strategy makes sense when the investor believes that the stock is undervalued, so that options premiums are inaccurate. In this case, the underlying belief would be that the puts are over-priced and the calls are under-priced, and there is a possiblity the stock will gap up on earnings.

Jun 19 07:13 AM

[TCK:]

Clarification ?

You suggest trading 20 total contracts. Then $30 to $50 to enter trade. Also may be assignment cost or commission to close one leg (10 contracts ) Another $25.00

Only collected $100 to open trade ?????


On Jun 19 07:13 AM Tom Armistead wrote:

> Trading costs for a retail investor (which I am) would be somewhere
> between 15 and 27.45 to trade 10 contracts, depending on the broker.
>
>
> Also not discussed in the article would be slippage - when making
> trades to exit the position there can be nickels and dimes on the
> bid/ask which adds up.
>
> Finally, it should be noted that the puts have to be backed by cash,
> so somewhere between 1,500 and 5,000 has to be available while the
> position is open, in the example given. Calculations of return on
> investment need to include these sums at risk.
>
> Options pricing assumes that the current share price is correct and
> that increases or decreases are more or less randomly distributed.
> This strategy makes sense when the investor believes that the stock
> is undervalued, so that options premiums are inaccurate. In this
> case, the underlying belief would be that the puts are over-priced
> and the calls are under-priced, and there is a possiblity the stock
> will gap up on earnings.

Jun 19 07:49 AM

[Tom Armistead:]

It's not about the 100. It's about a low cost trade that breaks even most of the time, but every once in a while the stock makes a big move. I think up is more likely than down, and the reward for up is larger than the loss for down.

On Jun 19 07:49 AM TCK wrote:

> Clarification ?
>
> You suggest trading 20 total contracts. Then $30 to $50 to enter
> trade. Also may be assignment cost or commission to close one leg
> (10 contracts ) Another $25.00
>
> Only collected $100 to open trade ?????

Jun 19 10:14 AM

[Tom Armistead:]

With JBL at 9.00 I closed by buying back the puts for .05 and selling the calls for .25, total profit was 300 less commissions of 70 = 230. I felt it was better to take the profits than to hang on hoping JBL could get over 10 by expiration.

Jul 24 02:39 PM