Handling Risk Around General Electric's (NYSE:GE) Earnings Report - D.R. Horton (NYSE:DHI), Caterpillar (NYSE:CAT)

General Electric GE reports earnings tomorrow before the open. GE has been a leader in the recent rally and has been a major influence on the price of the Dow Jones Industrial Average (DJIA) to the upside along with Caterpillar CAT. GE does not tend to be a volatile stock when compared to its Dow Jones peers. Even though GE is not an extremely volatile stock (relatively speaking) earnings reports can spur abnormal volatility.

Fundamental Analysis

GE obviously has its hands in many different pies spanning across several industries. This can make the shares hard to value, as can the sheer enormity and complexity of the company itself.

Looking at the analyst recommendations, the “outperform” consensus offers a slightly bullish bias from that perspective and the average analyst's target price is about $18 per share. GE has had a tendency to rally in the weeks following most of its last earnings reports, although remember that past performance does NOT guarantee future results. It is important to note that GE has topped consensus estimates for the past six earnings periods.

If the economy is truly in recovery mode, GE's performance this quarter should be on the upswing, not to mention it would be beneficial as an investor to listen to GE's earnings call as it can offer you quite a bit of insight and real raw data into the health of the economy. GE is trading at 13.5 times forward earnings ahead of the report.

Technical Analysis

Looking at the daily chart, you can see the stock recently broke out from a large channel that had contained it since July. The top of this channel puts support for GE just below the $17 mark. GE is currently above its 20-,50- and 200-day moving averages.

Option Strategies for GE

For this example, I am going to examine two longer-term strategies that have risk characteristics similar to long and short stock, but with a “buffer zone.”

When you buy a share of any stock, you will make $1.00 or lose $1.00 for every dollar move the stock shifts up or down. As soon as you buy or short that stock, your entry price is the breakeven point. In both these options strategies, when the stock is between the strikes that you choose, the position will have a delta of less than 100% (or 1). The farther the strikes are from one another, the lower delta the position will have when the stock is trading in between them. Note that these strategies are for educational purposes only. Prices are as of October 12.

Split Strike/Risk Reversal

For more advanced options traders who have a longer- term view on GE (either bullish or bearish), there are ways to get similar risk/reward characteristics of long or short stock, but with wider breakeven points and a lower delta when the stock is in between the chosen strikes.

Bullish example

Let's assume an investor is bullish over the next three-four months in GE and believes there is major upside in the stock, perhaps back to the $20 level or higher. He isn't sure, however, how quickly the stock will get there. In addition, he believes downside risk is limited and $16.50 is support for the stock.

If he wants an options strategy that behaves almost like long stock, he could examine a risk reversal. If this trader were to sell the March 17 put for $1.37 and at the same time buy the March 18 call for 91 cents, he would have similar risk as long stock but with a slight difference.

In this case, because the net credit is 46 cents, it is similar to being long the stock at $16.54 (the short put strike minus the credit). If GE is trading between the 17 and 18 strikes, the trader simply keeps the credit of 46 cents at expiration. Above 18, the profit potential is unlimited.

As you can see from the profit and loss graph below, this position currently looks just like being long stock. But once we move the time slide to expiration, you would see a flat line between 17 and 18, where the profit is limited to the credit received in this case.

This sort of strategy is used for traders who believe there is significant upside in the stock but may not want to pay the time decay to be long the out-of-the-money call. The strategy can also be potentially profitable if the stock remains in between strikes when the trade is done for a credit.

It is also important to remember that you have downside risk similar to stock (with the maximum risk being $16.54). As the stock moves either above or below your call or put strikes, the position will behave more like long stock or short stock, respectively, in terms of delta.

Bearish example

Investors can also create a semi-synthetic short stock position using a short call and a long put. Unlike the long risk reversal, the short risk reversal has unlimited risk, just like a short stock position. Skew (the difference in implied volatility between the call and put) may also be a negative factor when taking a short synthetic position.

Below is an example of a short split strike risk reversal using the March 17 call (short) and March 16 put (long) for an initial credit of 42 cents. In between 16 and 17, the strategy's reward would be capped at 42 cents. The maximum downside profit potential is $16.42 (the long put strike plus this credit). The upside risk, however, is unlimited. This would be a very bearish trade if you had extremely negative sentiment and did NOT believe there was a high probability of a rally.

Note the similarity to short stock in the risk graph below.

Before employing either of these strategies, check the margin requirements with your broker and be sure you understand not only the risks in the trade, but the points at which you break even. Financing a long option with a short option can help reduce cost, but it can also have a profound effect on risk.

Photo Credit: Mingo.nl

The above information is provided by OptionsHouse, LLC (“OptionsHouse”) for informational and educational purposes only and is not intended as trading or investment advice or a recommendation that any particular security, transaction, or investment strategy is suitable for any specific person. You are solely responsible for your investment decisions. Commentary and opinions expressed are those of the author/speaker and not necessarily of OptionsHouse. Neither OptionsHouse nor any of its employees, officers, shareholders or affiliated companies guarantee the accuracy of or endorse the views or opinions of guest speakers or commentators. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature and are not guarantees of future results. Any examples used that discuss trading profits or losses may not take into account trading commissions or fees.

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