Locking In a 20% Profit

Yum! Brands will announce earnings after the close on Tuesday (7/14/2015). We entered a long stock position in YUM back on February 11th. My justification was:

Yum! Brands (YUM), parent of Taco Bell, KFC, and Pizza Hut restaurants, has an incredible seasonal track record. Over the next 15 weeks, YUM has risen an average 12.5%, with gains in every one of its 17 years! Assuming an option trader would need to see at least a 5% move for a typical option trade to work, there were only 2 years this trade wouldn't have worked!

My trade setup focused on buying the stock, but also considering a July 67.5 call as an alternative trade. The YUM stock trade is currently up 22% and the alternative July 67.5 Call is up 151%. So we have a good profit, for 6 months of work, with both the long stock and long call trades.

But with earnings coming up, a few concerns arise. If YUM! Brands earnings meet expectations, no problem. This stock probably will continue consolidating, building strength for the next leap upwards. If we knew this was the likely result, we would want to hold onto the stock.

If YUM! Brands exceeds expectations, the stock will jump. If we knew this was coming, we'd certainly want to hold onto the stock.

The problem is if YUM! Brands' earnings disappoint. There are a variety of opinions on what YUM! Brands will announce. Some analysts point out that 52% of their revenue is tied to China, and China is not doing well right now.

Looking at the stock's recent history, YUM! Brands surprised on earnings back in April and within 2 weeks the stock was up 14%. But YUM! Brands also gave downside guidance back in December and the stock quickly lost 8%:

So what are the options for someone holding YUM stock right now? Our Seasonal Forecaster newsletter-based trade is up 22%. If YUM! disappoints, I could see the stock falling to the 85 area. If YUM! exceeds expectations, I could see it jumping to 95. Visually, this is the situation we're faced with:

If I bought this stock as a long-term investment, I would hold it. YUM has decent fundamentals, which the company is working on improving (the April earnings surprise shows they are making some progress). It pays a 1.8% dividend, with 10 years of consecutive dividend increases.

If I bought this stock as a short-term trade, I would sell the stock right now and wait for earnings. After the stock reacts to earnings, I could evaluate re-entering a position in the stock. And of course, if I had entered the alternative trade, the July 67.5 Call, I should immediately close out the trade to not only capture the 150% profit before earnings, but also because the option will expire at the end of this week.

But is there another way to hold on to the stock, yet protect against a sharp drop? Can we lock in our profit and still keep the stock?

Yes. It's called a protective put, and in this case, because we already have a good profit, it will guarantee a minimum profit level even if earnings are horrible and the stock drops 50%. We can consider using the new weekly-expiration options, specifically an in-the-money put that expires the week following this week's earnings. So let's take a look at how this would work.

If we are holding the stock from our February 11th entry, and assuming we bought 100 shares, we are currently up $1,663, or 22.4%. If YUM reacts negatively to earnings and falls to the 85 level, our profit would drop to $1,077 and we'd be up just 14%. Of course, if YUM dropped even more, we could give back even more of our profit, and maybe even end up in loss territory.

We could add a protective put. Since we want only a few days of protection, enough to get through YUM! Brands' earnings later this week, we can consider a YUM weekly option, such as the July 24 2015 expiration 95.5 Put (currently mid-priced around $6.32). There is very little extrinsic (time) value in this option, so it will move about $0.70 for every dollar YUM stock moves. Our intention will be to sell it right after earnings, once the protection is no longer needed.

The profit/loss picture of just the option position looks like:

(These are theoretical values, which may not match actual prices)

The profit/loss picture on the combined position shows that this approach will ‘lock in' a 20% minimum profit, no matter what happens. YUM could fall 50% and we'll still walk away with at least a 20% gain (if we close out the combined position on 7/15/2015):

Now of course we give up a little of the upside by buying this insurance. The put will lose value if YUM heads upwards, although it is offset by the gains in the stock. If YUM rose, we would make more if we held just the stock, but giving up some of the potential profit is the cost of buying insurance.

Since we are already showing a decent profit in our YUM position, a protective put can be used to lock in a minimum gain for a short period of time. This is a good technique to use for any stock you want to keep, as long as there are actively traded options on it.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, please click on the following link: www.markettamer.com/seasonal

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2015 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com.

The content on any of Market Tamer websites, products, or communication is for educational purposes only. Nothing in its products, services, or communications shall be construed as a solicitation and/or recommendation to buy or sell a security. Trading stocks, options, and other securities involve risk. The risk of loss in trading securities can be substantial. The risk involved with trading stocks, options and other securities are not suitable for all investors. Prior to buying or selling an option, an investor must evaluate his/her own personal financial situation and consider all relevant risk factors. See: Characteristics and Risks of Standardized Options (http://www.optionsclearing.com/publications/risks/riskstoc.pdf). The www.MarketTamer.com educational training program and software services are provided to improve financial understanding.

 

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