With earnings announcements happening daily in the coming weeks, investors may wish to consider buying some temporary insurance in the form of protective puts.

As we wrap up the third week of January, we are entering the "heart" of the Q4 2021 earnings season, one of four such seasons we encounter on an annual basis. We typically find that earnings season produces some added volatility and potholes for investors to avoid. With earnings announcements happening almost daily in the coming weeks, many investors may wonder: "Am I going to hear any bad news from the companies that I own? And if the news is not good, how will my positions hold up?" Fortunately, if you'd rather not just sit aside and hope you are lucky enough to avoid any earnings disasters, you have the option to buy some temporary insurance in the form of protective puts. First, we'll review a few basics on puts, and then we will go over an example that typifies the successful use of the protective put strategy. Many investors have difficulty understanding puts when they are pretty simple. If you own a car, you likely own a put on it, provided you carry collision insurance. A put is simply a contract giving the buyer the right, but not the obligation to sell stock at a specific price (the strike price) during a specified period. The underlying stock can be "put," i.e., sold to the writer of the put for the strike price, anytime between the time the option is purchased and the time it expires. Similarly, if you have an accident in your car, you have an insurance policy that states that the underwriter will pay you the cost of the damage. Conceptually, a put is the same thing -- you pay a premium to protect your stock; the only difference is that you are insuring against damage to the value of your stock rather than to your car. In either case, if an accident occurs, your losses are mitigated by the insurance you purchased. 

Example of Using Protective Puts:

Now that we've discussed the basics of how puts work let's look at an example of using protective puts to protect your portfolio during earnings season.

In the chart below, you can see that XYZ Stock broke out of a base at $244 before notching a new high of $276 by the end of February. At that time, XYZ was moderately overbought at around 51% and was in a solid technical uptrend. By the time XYZ had reached its peak, the stock had a technical attribute rating of 3 and gained relative strength versus the market and its peers over the short term.

In March and the first part of April, XYZ had a relatively significant pullback to $248. In April, the stock reversed back up into a column of X's just ahead of earnings season. By then, XYZ was a prime candidate for a protective put, as the stock was just below February highs, and there was no material support on the default chart until just above the bullish support line. On April 30, the day of Q1 earnings, XYZ May $250 puts could be purchased for $9.05. By doing this, you would have hedged against a possible bad earnings call and provided yourself with some peace of mind.

XYZ's Q1 earnings call took place after the market close on April 30. XYZ's stock opened at $252.13 the following morning; however, by the end of trading, the stock had declined by $53.73 (more than 21%) to close at $198.40. In just one day, XYZ's overall technical picture went from promising to an overall negative trend as it lost all three of its positive technical attributes. By the end of the day, the May $250 put was trading at $50.10, a gain of just over $41 compared to the previous day's price. The $41 gained by the put would have notably mitigated the 21% drop in the stock's price. Ultimately, while most XYZ shareholders experienced significant losses, those who purchased the $250 protective put would have suffered a net loss of only $12 per share than the over $50 per share loss for those who had no insurance. While this example may not be typical, it is not unique either; there is often significant and unpredictable volatility following earnings announcements. 

An essential characteristic of protective puts is that they do not cap your upside potential (as does selling calls against a position, for instance). Instead, if the stock you have hedged with puts continues to move higher going forward, you participate in the upside at all points, and your returns are only diminished by the premium paid for the put. 

Our example illustrates how protective puts can work to your benefit. But remember, protective puts are just like car insurance – no one appreciates having it until they need it. Just as you don't relish paying for car insurance, no one is excited about paying the premium for a protective put. But, just as with any other insurance, you pay a put premium not because you expect to have an accident, but because you know you'll be protected if you do. You have to ask yourself whether it is worth laying out the premium to have this insurance in place. If the answer is yes, then consider buying protective puts on stocks you may own. In the example above, we presented this strategy to hedge against a negative earnings result in the short term. Of course, you can also buy longer-dated puts if you're seeking protection for a more extended period. 

Note: The example above is not fictional. This was the actual experience of LinkedIn shareholders following the company's Q1 2015 earnings release. LinkedIn was acquired by Microsoft in June 2016. 

Consider Using Protective Puts as Insurance:

We often find that a hedged approach makes sense in several situations you are likely to encounter during earnings season. One situation when we find the use of protective puts to be especially appropriate is in the case of overbought stocks with upcoming earnings and no meaningful nearby support. A prime example is Brixmor Property Group Inc. BRX, which printed a new multi-year high at $27 with action on Thursday, January 13 and is scheduled to report third-quarter earnings on Monday, February 7. BRX is a perfect 5 for 5’er that ranks in the top quartile of the real estate sector stock matrix, confirming its strength versus its peers. BRX trades on three Point & Figure buy signals and sits well above the bullish support line. Since giving the last buy signal at $18.50 in March of 2021, BRX has pushed significantly higher to $27 where it is trading on a significant stem. When we use Thursday’s closing price of $24.52, we can see that BRX is currently trading about 32% from initial support on the default chart that sits at the $16.50 level. Using BRX’s support level as a stop loss when trading at multi-year highs may not be a palatable option for those with significant capital gains in the position, especially since the stock is up 40.68% over the last year (1/20/2021 – 1/20/2022), significantly outperforming the S&P 500's SPX return of 16.38% over the same period. Given all the aforementioned information, BRX is an ideal candidate for using protective puts to protect against a potential post-earnings decline. Because we are specifically concerned with protecting against earnings-related decline and earnings are expected on February 7, holders of BRX may wish to consider the February 18 $25 puts, which are currently trading around $0.95. We have no way of knowing how the market will react to BRX’s earnings release scheduled in the next few weeks, but we do know that uncertainty around earnings releases increases the potential for price volatility, and therefore, implementing such a strategy ensures that we are protected no matter what happens to the stock.

Because our focus is to hedge against unexpected volatility during earnings season and due to the fact that option prices increase as the time to expiration increases, we want to pay for as little time as possible. That said, we will want to focus on February 18 puts. We tend to recommend at-the-money (or slightly in-the-money) puts so that you have sufficient delta going for you (delta is the change in the option's price due to a change in the price of the underlying). Following an earnings announcement, you can reevaluate any put positions you've purchased, depending on how the given chart looks, how the stock has reacted to the earnings announcement, and perhaps how many of its peers may also be reporting soon. Ultimately, you want the reason that you bought the stock (or put) to be the primary determinant for maintaining or closing out a position.

A Few Points to Remember When Considering Protective Puts:

1. Only buy 1 put for every 100 shares you own (or want to hedge). Don't over-leverage by buying more options than you need to protect your position.
2. Today, the CBOE SPX Volatility Index VIX sits at 26.79 on its Point & Figure trend chart, which is above its long-term average of 19.64.
3. The protective put gives you insurance against a significant pullback but doesn't cap your upside potential.
4. Lastly, you may own stocks that are still technically sound overall: trading in an overall uptrend and at least a 3 for 5'er (or higher). But they may be extended, and a considerable distance above notable support, similar to BRX in our example above. A protective put strategy is a good way to protect profits you may have built up in these positions in your portfolio.

For those interested, you can go to any number of sources to get a list of stocks due to report earnings in the coming weeks, or you can check our website (check out the "Activity" report in the Portfolio tool or click here to see the "Stocks with Upcoming Earnings Releases" report, which can be found in the Security Screener -> Database Reports -> Stocks with Upcoming Earnings Releases). With earnings season in full swing, there are many stocks that will be announcing earnings soon and are viable candidates for protective puts. With that said, below is a list of S&P 500 Index SPX stocks that are due to report over the next two weeks. (Source: FactSet) *All price and technical attribute data below are through 1/20/2022. All expected earnings dates are as of 1/20/2022 and are subject to change.