Royal Bank Post Earnings Play

Royal Bank (TSE:RY) announced earnings December 2nd and surprised the street with a resounding beat of the estimates. According to Reuters Canada, the banking giant reported an 11% rise in fourth quarter profit ” …driven by at its personal, commercial banking and capital market businesses” (Thomson Reuters Dec 2)

While they did cite a concern for the oil dependent regions of the country, the market liked what it heard as shares jumped at market open and are up just over 1% from yesterdays open.

As a student of technical analysis, a study of the price action leading into the announcement indicated that traders and investors were uncertain about what to expect.

If we take a look at a daily chart, a sideways triangle can be observed forming, beginning the first week of November. This pattern is identified by lower highs and higher lows and often forms ahead of important announcements. It is often referred to as a coil.  The consideration is that the price action becomes tighter as the event approaches and, much like a coil or spring, there is a build up of “energy” and anticipation that tends to resolve with a volatile move.  The challenge is determining which direction.

TSE:RY
Daily, December 2, 2015

From an option traders perspective, this kind of pattern represents an opportunity to implement a Straddle or a Strangle. Since there is no short term directional bias, and a significant build up of “energy” and anticipation, there is the potential for a significant move in either direction.  As a note of caution, this build up of energy and anticipation also comes with an increase in implied volatility, making options more expensive ahead of the announcement.  The trader runs the risk of a volatility crash once the numbers have been released.

From an investor stand point, this may be an opportunity to get long the stock.  To keep it easy, I have added a 200 bar exponential moving average to the chart below.  The last 3 days price action, combined with the positive earnings have resulted in some commitment above the longer term average.  This 200 bar EMA line can now be used as a support level supporting a bullish up trend.  As long as the share price remains above, the stock can be considered bullish.

TSE:RY
Daily, December 2, 2015

For the investor who is still concerned about the bigger picture, a stock replacement strategy with a limited risk would be worth considering.  The January 2017, 76 strike call is asking $5.75. This represents a maximum risk of $5.75 per share or 7% on the present value of the stock if the shares drop. This is also a compelling idea from a capital leveraging perspective.  The investor who purchases 100 shares will put up approximately $7700.00 while the purchase of the long term option requires only $575.00.

The trade off is that if the shares are at or below $76.00 on expiration, the option buyer loses the entire premium while the share holder may continue to hold the stock and collect dividends.  That said, the option trader can implement a Calendar Spread strategy outside of his or her registered accounts.  The rationale would be to sell out-of the-money calls monthly against the longer dated option contract.  This will bring in consistent cash flow and lower the cost basis of the position.

For example, Once the January 2017,  76 call has been purchased, a January 2016 80 strike call may be written.  The current bid is $0.45.  This represents almost 8% of the purchase price of the 2017 call.  By selling monthly, out-of the-money options, the investor can make a sizable dent in their cost basis, break-even point and risk exposure.

While a traditional investor only has 1 way to capitalize on this recent move,  an investor who has integrated options into their game plan as a considerable number of alternative strategies to choose from.

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