How Not to Lose Money on a Bad Earnings Report

James DiGeorgia

Let me start by commending Uncommon Wisdom Daily’s newest analyst, Frank Curzio.

I think his recent article “Oil Prices: Heading Back to $100!” and the points articulated are spot-on.

His commentary was especially brave amid Wall Street’s predictions of gloom, doom and below-$60 oil. It’s especially cogent and outlines a significant profit opportunity developing in the beaten-down oil patch.

Speaking of oil, what’s happened in energy these past few months may have made some investors shy about adding new stocks.

However, there’s a strategy that serious stock investors can use to protect themselves from a pullback.

Today I’ll show you how I’m using it in my own trading, with a stock that’s set to report earnings this morning …

As I’ve said before, I am a big believer in the potential upside for the Chinese Internet discount commerce giant Vipshop Holdings Ltd. (VIPS).

(Disclosure: I own VIPS and have held this particular position for just about 30 days.)

And until last week, all of the indicators I follow were indicating an all-out buy — with 5 of the 6 indicators being positive.

But then, something changed  …

I entered my position at about $22 a share. My target price for the VIPS was $29 a share.

But by midweek last week, these critical indicators quickly moved to neutral and then to a clear sell signal.

As I pen this note, VIPS has pulled back to $21 and change.

4 of the 6 Erlanger sentiment indicators were positive,

indicating a buy, when I entered the position.

Now only one indicator remains positive!

Normally I wouldn’t worry.

That’s because, in the past, VIPS has pulled back just before earnings.

It has even flashed a sell signal … only to beat estimates and rally!

But also in the past, VIPS has gotten a great tailwind from the success and growth of other Chinese Internet plays.

Unfortunately, this time around, Chinese Internet companies are struggling.

For example, last week Baidu Inc. (BIDU) plunged 10% after missing Q4 earnings expectations. It continued to sink through last Thursday’s trading session before regaining some ground Friday.

Many other Chinese Internet, communications and technology stocks were also high-fliers in 2013 and 2014.

Consider names like (SOHU), SINA Corp. (SINA), Youku Tudou (YOKU) and even the hot IPO Alibaba (BABA) that launched near the end of last year.

Now consider that those names are down 30% to 60% from their highs!

As China’s economic growth has cooled, so have investors’ appetites for Chinese stocks.

Before concerns about a macro-economic slowdown in China intensified, many analysts following VIPS expected it to grow sales by 80% to 84%.

Here’s one tailwind that could push it higher  …

In Q3, VIPS began upgrading its mobile application to make it much more customer-friendly. This was expected to boost Vipshop’s top line in the fourth quarter.

After all, during that time, many more Chinese consumers switched from computers to mobile devices to shop online.

Here’s another potential tailwind for the stock  …

The fourth quarter also included the China’s “Singles Day” holiday on Nov 11, 2014.

That’s when Chinese e-commerce players usually cash in big with strong online sales thanks to deeply discounted offers and one-time promotions.

Yet despite all this potential, VIPS shares are sagging … and so is my stock investment.

Most investors would have cut their position loose, after the terrible Baidu report.

But not me.

I guess I’m too stubborn about VIPS’ ultimate-long term potential to cash out and sit on the sidelines.

But that doesn’t mean I have to lose a ton of money if they have a lousy fourth-quarter earnings report.

Time to ‘Put’ on Some Put Insurance

So instead of closing my positions, I decided last Tuesday and Wednesday to buy “put insurance.” That is, I bought put options to hedge my long shares against a pullback.

I own1,500 shares of VIPS, and each VIPS options contract represents 100 shares of the underlying stock.

So, I bought 15 of the VIPS February $20.50 Puts at an average of $60 per contract to hedge my long shares in a 1-to-1 ratio.

Here’s how that worked:

  • Buy 1,500 VIPS shares at $22 ($33,000)
  • Buy 15 VIPS February $20.50 Put contracts at $60 ($900)
  • 15 contracts x 100 shares in a contract = 1,500 shares hedged

Now, if you look at the bullets above, you see a roughly $900 spend for those puts.

However, as VIPS shares grinded lower last Thursday, the puts more than doubled to $1.35 in value.

So, the falling share price didn’t bother me too much. That’s because, while I was losing money on the shares, I was making money on the puts!

By buying these puts, I essentially added 60 cents to the cost of my position. My cost investment in the 1,500 shares now averages about $22.60.

If VIPS disappoints, it could very easily fall to $12.25 a share — as indicated by the price target generated by the Alpha Scorecard, which evaluates trading ideas on a free cash flow basis.

If VIPS slides that far, I could see a possible $10 loss on the position from current levels …

 … that is, if I didn’t own put options to protect against a slide!

Remember, I bought the put options at the $20.50 strike price. Instead of facing a potential loss of 45%, I am now hedged.

So, if VIPS has a bad fourth-quarter report and the stock takes a hit, I will limit any potential loss to about $5 a share — roughly a 20% loss.

Options have so many wonderful uses.

  • Some people buy calls and puts to speculate whether stock prices will rise or fall.
  • Others sell calls against their long stocks to generate income, or sell puts to have shares “put” to them at a favorable price.
  • But far fewer seem to use them this way, by buying puts to hedge against potential losses.

In this case of VIPS, the downside could be as much as $10.35 from the current price level.

So by buying the $20.50 puts, I am hedging against a terrible potential loss, simply by adding 60 cents to cost of each share I own.

That’s a pretty good insurance policy, if you ask me!

If the stock goes down, I can exercise my right as a put-buyer to “put” my shares to someone who is short the puts at the $20.50 strike.

If the stock goes up, I can exit out of the puts and remain with my long shares.

That’s why I want to use this strategy instead of exiting the stock. I think that there’s more upside to capture. And I want to be on board to capture it!

Owning puts alongside my long shares allows me to stay positioned in a stock I believe really could hit the Alpha Scorecard lower limit price target of $32.32 — which is now 43% higher than the cost of my position ($22.60).

Long term, I could see VIPS climbing to its Alpha Scorecard upper limit price target of over $100.

Buying puts against a long position like this — going into earnings, for example — can help you to protect yourself from a nasty surprise.

Since this article is being published Monday, just before VIPS reports, you’ll be able to judge today whether using puts in this case makes sense.

If VIPS is up a few dollars and climbing, the expense of buying the put may end up being just that: an expense.

But if VIPS drops more than 20%, say a nosedive to $12-$14, you’ll easily recognize the effectiveness of this important hedging strategy.

Please note that this VIPS example is not meant to be taken as a recommendation. But I do hope that the next time you have a stock you love long-term that might endure some short-term pain, you’ll consider buying some puts to help minimize it!

Always Watching Your Chickens,

James DiGeorgia