Tuesday, July 13, 2010

YUM Watch

Yum! Brands Inc. (YUM), which owns KFC, Taco Bell and other fast food giants, and which does a land-office business selling crunchy goodness in China, is drawing a lot of interest in the options markets as an earnings surprise play. But is it a wise play, and how can it be played for maximum profit?


YUM's earnings are scheduled for release after the market close, with a consensus estimate of 54¢ per share, and the stock tomorrow will go ex-dividend on a 21¢ payout (2.03% annualized).

A trader must form an opinion on one, possibly two, questions when setting up an earnings play: Will the surprise be enough to move the price enough for a profit? If the direction matters to my chosen vehicle, which direction will it go?

An earnings play is a volatility play. The trader wants to profit if the stock moves. One way of doing this is by buying or short-selling shares, or by buying call options or a put options. Those vehicles mean that the trader profits by guessing the right direction of the move. If the move is in the opposite direction, then the trader loses.

A direction-neutral play is a complex options construction called a straddle, where the trader buys both calls and puts with the same strike price, generally near the current trading price.

In the case of YUM, now at $41.37, it would work like this:
  • Buy the 41-strike call.
  • Buy the 41-strike put.
  • Net cost: A $3.30 debit.
  • Maximum loss: $3.30.
  • Maximum gain: Infinite

In the past year earnings announcements have generally moved the price of YUM by about $2. So, with this straddle, a positive earnings surprise that bumps the stock up to $43 produces a profit of about 40¢, or 12%. A negative surprise that lowers the stock to $39 produces a 30¢ profit, or 9%. Either way, it's a great return for very little work.

If the stock price doesn't move, then the trader is out the commission, not very much when using a discount online broker.

On a single call option (the October 38 for this example), costing $4.50, a $2 positive surprise would produce a $1.20 profit, or 27%. A negative surprise would produce a loss of $1.60 or so, or 35%.

Read more on straddles at Investopedia. Also, check my post from yesterday on the strategy of seeking out surprises in trading.

In the case of YUM, I see it as a positive surprise, and today's trading says that the preponderance of traders see it that way, but with some reservations. The price gapped up this morning, but has pulled back intra-day.

The stock has been trending sideways since April, between around $38.50 and $44, and the price now is midway between the extremes.

In terms of reversal levels, there's plenty of room to run to both the upside and the downside, so that's no help at all.

My preference in playing YUM would be for a direction neutral strategy, using a straddle.

Reversal Levels
  • $43.50, +5.2%
  • $41.37 <== You are here.
  • $38.25, -7.5%

The Great Reflation: How Investors Can Profit From the New World of Money
OK. The credit bubble burst. Housing, burst. Shockwaves reverberated. Markets collapsed. What lies ahead as we reemerge from the wreckage.

Tim Bovee, Private Trader tracks the trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment. No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decision decisions for his or her own account, and take responsibility for the consequences.
  • psar - Parabolic Stop and Reverse
  • adx - Average Directional Index
  • pps - Person's Proprietary Signal
  • ma20 - 20-day moving average
  • macd - Moving Average Convergence-Divergence
  • sto - Fast Stochastic
About the glance: The colors indicate the state of each signal.
  • trend: Determined by the 5-day moving average, green for up, red for down, yellow for sideways
  • adx: orange for above 30-up, blue for 20-down, purple for in the middle. Red is most prone to whipsaws
  • psar, pps, macd: green for bull mode, red for bear
  • sto: green for overbought, red for oversold, yellow for the neutral zone.

No comments:

Post a Comment