Related Company Earnings Risk

by Mike Scanlin

Covered calls are a nice, conservative, income-oriented investment strategy. As long as you stay away from high volatility events and companies, you should be able to sit back and collect premium all day, right?

Well, imagine you have your trusted covered call scanner configured to reduce risk. Among other things, you tell it to only find covered call opportunities that don't have an earnings report due before the option expiration date.

A whole bunch of juicy premiums sort to the top of the list, none of which have an imminent earnings report. You're golden. Life is good. Fat returns without earnings risk!

But wait... There could still be earnings risk...

Related Companies Could Have Earnings Due Soon

Even if the company you are looking at doesn't have earnings before option expiration, it's possible that a company in their space could have earnings before expiration, which is forcing the premiums higher on both companies (or all companies in the space).

For example, Research In Motion's (RIMM) next earnings is expected March 28. Wanting to avoid earnings risk, you take a look at the February 16 expirations and find annualized returns that are quite high for the deep in the money options:

Normally you don't see something with 27% downside protection (meaning, the stock would have to drop more than 27% from current price for you to lose money by Feb 16) that pays a 16% annualized return. Unless there is a pending earnings announcement, of course. So what gives?

The answer is Apple (AAPL), which releases earnings Jan 23. That's prior to the Feb 16 expiration date of the RIMM options you're looking at. Because AAPL competes with RIMM, its results will affect RIMM. Apple's earnings could imply something about RIMM's market share, or the whole smart phone market in general, or declining margins in the space, or a host of other factors that would be relevant to RIMM. The fact is, AAPL's results will move not only AAPL but other companies like RIMM as well.

Another Example With Weekly Options

Imagine you've got your screener set to find weekly options. Green Mountain Coffee Roasters (GMCR) shows up as something that doesn't have earnings until after the next weekly expiration date, and it's offering a fat premium. You're in the clear for an in the money trade next week, right? Just look at these returns:

Why such fat premiums? After a little research you find out that Starbucks (SBUX) releases earnings on Jan 24, the day before these weeklys expire Jan 25. Clearly SBUX's report will affect GMCR. Potentially in a radical way. Which is why GMCR offers such high premiums during a week when it has no expected announcements.

So, How Do We Proceed...?

The lesson here is that you can't just blindly screen for fat premiums when selling options. You need to do some homework and figure out why the premiums are rich. Many times it is something to do with the company itself (product, earnings, FDA approval, etc) but it can also be for extrinsic reasons, such as something to do with a related or competing company, or an election, or other anticipated macro event (credit downgrade of the US, for example).

Discovering the reason for the fat premiums doesn't mean you shouldn't invest. But at least you know what you're getting into and can then decide if the extra reward is worth the anticipated extra risk.

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.

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