Lessons From The Trade On Joy Global's Earnings: The Importance Of Context

Jun. 1.12 | About: Joy Global (JOY)

On Tuesday, May 29, I described a trade on Joy Global (NYSE:JOY) earnings featuring a bullish bias with a hedge. I concluded that the odds slightly favored an upside move. I also concluded that JOY was likely to experience a very large move no matter what direction it swung post-earnings. This combination of odds compelled me to include a hedge in the JOY earnings play, even though I typically avoid hedging earnings plays due to costs. I ended up staging the trade by executing a put spread into the run-up on Tuesday and then buying calls on the subsequent sell-off the next day. I posted these trades on my twitter feed using the #120trade hashtag.

JOY ended up disappointing investors by slightly guiding down earnings and revenue forecasts for the current fiscal year: EPS of $7.15-$7.45 from prior guidance of $7.40-$7.80 (excluding non-recurring items) and revenue of $5.5 billion to $5.7 billion from prior guidance of $5.6 billion to $5.8 billion. The guidance came along with a lot of commentary regarding weakening economic conditions in China (I will cover more details on that in a future post). Investors and traders clearly found little solace in JOY's expectation that the Chinese government will ease loan requirements and start spending more. In the current bearish and negative market environment, the existing reality matters a lot more than hopes for the future. The end result was a drop in JOY to as low as $53.26 and a loss of 9.8%. JOY managed to bounce sharply and close with a 5.3% loss.

I closed the put spread and will end up with a small profit no matter what happens to the calls I am still holding. My decision to buy a put spread instead of just buying puts outright put a tighter cap on profits than I anticipated. In particular, the short side of the put spread maintained a lot more value vs. the long side than I expected. I also gave up another chunk of profit as the position stopped out on JOY's bounce back through $55 (I wanted to preserve an overall profitable trading play). The irony here is that the spread only marginally reduced the cost of the bearish side of this bet. I learned a strong lesson in being "too cheap."

The biggest lesson from this experience is that context can matter a lot for earnings plays. If I had mechanically applied my standard analysis and rules for earnings plays, I would have only bet on upside (albeit in a much more conservative way, like a call spread). I would have lost out on the opportunity to squeeze lemonade out of lemons. The large swings ahead of earnings tipped me off from a qualitative standpoint; from a quantitative perspective, I now need to add a study of pre-earnings volatility (or price range, not just average change).

The technical context turned out to be extremely critical as well. As I mentioned in the previous post, I figured that a break of support would create a lot of damage to the stock. That is exactly what happened. JOY traded right down to the edge of support ahead of earnings. After earnings, JOY crashed through 2011 lows and now sits at near two-year lows. In fact, JOY has now erased all its gains that followed the Federal Reserve's second phase of quantitative easing (QE2). This return to what I call "the QE2 reference price" follows a well-established pattern among most commodity-related stocks.

Joy Global crashes through 2011 lows and hits its QE2 reference price:

Click to enlarge image.

Joy Global crashes through 2011 lows and hits its QE2 reference priceClick to enlarge

Source: FreeStockCharts.com.

Finally, the large price range in JOY's post-earnings trading has also taught me that I need to include a quantitative study of post-earnings lows and highs, not just the close, when correlating to previous price history. I have already done a little of this when looking at the tendency of Best Buy (NYSE:BBY) to fade post-earnings and for Amazon.com (NASDAQ:AMZN) to hold its lows for at least two weeks. JOY demonstrates that it is probably also useful to understand the correlation between maximum potential gains/losses and previous history. Stay tuned for the next round of earnings analysis.

Disclosure: I am long JOY. Still long JOY calls left over from earnings trade.