Wednesday, January 23, 2013

COF: A bearish break after earnings

Capital One Financial Corp (COF), the credit card and everything else money company, broke below its 20-day price channel on Tuesday, generating a bear signal on the second day after a large earnings-inspired downside gap.

My rules for trading earnings surprises are these: Don't trade on earnings day. Don't trade the day after. Do trade the next day, but only if there's a fresh breakout beyond the price channel. COF meets those rules.

Capital Finance in its Jan. 17 report missed earnings estimates by 11.8, a major error for a company that size in its management of expectations. Expectations crashed in the form of an opening price, $56.59, that stood 8.1% below the prior day's close, $61.59.

The post gap decline on Tuesday carried the price below its lowest level, $56.21, for the past 20 trading days, producing the signal. The price continued lower today, confirming the breakout.

COF has been in a holding pattern since last November -- sideways with some internal trending. Big picture, the stock has been trending upward since October 2011.

A pre-earnings rise began with an upside gap on Dec. 31, carrying the price from that day's low of $56.47 up to a swing high of $62.92 on Jan. 7. The price crash on earnings essentially wiped out the results of that five day trend.

If COF's decline continues, then the next significant resistance is at the 55-day price channel boundary, $54.45. That gives about 3% of easy movement before resistance.

COF has a history of successful trades when it breaks out to the downside. Nearly eight out of 10 (76.5%) have been profitable over the past four years, with an average gain of 7.6%.

The return adjusted for the success rate is 5.8%. That's not particularly high -- my minimum for consideration is 5% -- but COF is a very liquid stock, and that means I can expect good fills on options for some decent leverage.

Analysts going into earnings liked COF a lot, with a collective enthusiasm index of 54%. How well that will hold up in light of the earnings miss is anyone's guess.

The McLean, Virginia company attributed its poorer than expected results to seasonal factors, in the form of "expense and margin trends". I don't entirely get that, since seasonal things can generally be anticipated and mitigated. But then, I am not a fundamentals trader.

Capital One's financials put in the category of slow and steady, with a return on equity of 8% and debt amounting to 61% of equity.

Its earnings have a slight tendency to peak in the 1st quarter -- credit cards? Christmas shopping? -- and that quarter has been higher for at least the past two quarters compared to its year-ago counterpart. However, quarter to quarter, there is no trend. Earnings are all over the place.

Looking at the last 12 quarters, all have been profitable, nine have surprised to the upside and three to the downside.

Institutions own 87% of COF shares, and the price is a bit above sales parity. It takes $1.53 in shares to control a dollar in sales.

COF on average trades 7.7 milloin shares a day, enough to support good selection of option strike prices with four-figure open interest. The front-month at-the-money bid/ask spread on puts is quite narrow, at 3.3%.

Implied volatility stands at 23%, the low point of its six-month range. It has been generally trending lower since Dec. 31.

Options are pricing in confidence that 68.2% of trades will fall between $52.44 and $60 during the next month, for a potential gain or loss of 6.7%, and between $54.40 and $58.04 during the next week.

Option trading is running 20% above its five-day average volume for calls, and 17% below average for puts, giving a slightly bullish mood to current speculation.

The fair-price zone on today's 30-minute chart runs from $56.10 to $56.38, encompassing 68.2% of transactions surrounding the most-traded price, $56.20. With three hours left before the close, the stock is priced near the most-traded level, since most of today's decline occurred during the first 90 minutes of trading.

Capital One next publishes earnings on April 15. The stock goes ex-dividend in March for a quarterly payout yielding 0.36% at today's prices.

Decision for my account: I've opened a bull position on COF, structuring it as a bear call options spread expiring in February, short the $57.50 strike and long the $60 strike. The position is profitable up to $57.97 and has a maximum potential yield of 23%.

If the price continues to fall, I'll add to the position through the purchase of June put options with delta as close to 70 as I can manage.


My trading rules can be read here.  A discussion of recent modifications to my trading methods, which haven't yet been incorporated in the original write-up, can be found here.

And the classic Turtle Trading rules on which my rules are based can be read here.

Tim Bovee, Private Trader tracks the analysis and 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.

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