Posted on 13 December, 2009 | No Comments
Research in Motion is a real Canadian success story. The company is worth more than $36 billion. It generates over $600 million in profit every quarter. It carries no debt on its books. It has a dominant position in the US with a market share greater than 55%. And it is expanding aggressively into sought after international markets including Russia and China.
Yet, in spite of all its past success, the company has become an enigma for investors and analysts alike. Today, price targets vary from a low of $50 to a high of $120. In the past three months alone, the stock hit a high of $85 (USD) in late September; crashed in October/November to $55 (USD); and rebounded last week up 11% to close around $63. Now this is a volatile stock.
3rd quarter earnings will be announced after market close on Thursday December 17. Interesting enough, RIM’s stock tends to be most volatile the day after it announces its earnings. An analysis of the last 6 quarters of earnings announcements shows that RIM’s stock tends to go either up or down an average of 18%.
Here are the percent changes in prices from 1 day before earnings announcement to 2 days after the announcement for the last 6 quarters:
2nd quarter: 2010 -11%
1st quarter: 2010 -29%
4th quarter, 2009 +10%
3rd quarter, 2009 +32%
2nd quarter, 2009 -16%
1st quarter, 2009 -10%
While there is no guarantee that history will repeat itself, this kind of statistical information suggests there is a high probability of a considerable move up or down later this week. It also suggests that the share price adjusts very quickly to changes in announcements.
It thus begs the question: Is there a way for an investor to play RIM so that the investor benefits in the case where earnings exceed expectations and the share price jumps; and at the same time, losses are minimized in a case where RIM disappoints and the share price tanks.
Basically, the investor wants upside benefit with limited downside risk. Sounds too good to be true – perhaps not. For option players, RIM presents a rare potential opportunity.
For those who have forgotten, a call option gives the owner the right to buy shares at a specified price. Currently, an investor could purchase a December 2009 call option with a $65 strike price for $2.30. Should the stock trade below $65 at Friday’s close, the call option will expire worthless (because no investor is going to exercise his right to purchase RIM shares for $65 when he could buy it in the market for less).
Keeping in mind the following two facts: (1) that the stock is currently trading in the $63 dollar range and (2) a December 2009 call option expires literally in five days on Friday December 18th; it almost seems ludicrous for an investor to spend $2.30 on something that looks like it will be worthless in less than a week.
Interesting enough, however, the call option presents some attractive scenarios. The worst case scenario for the call option buyer is a loss of $2.30. This scenario happens if the stock trades below $65 at market close this coming Friday, December 18, 2009.
However, in a best case scenario, the call option buyer gets to enjoy all the upside if the shares trade above and beyond $65. In a case where the shares trade above $65, that same investor will exercise his call option right; he will purchase the RIM shares outright for $65; and perhaps sell them for a profit the following Monday morning at the higher price to realize a profit or continue to hold onto the shares.
Needless to say, for this strategy to be profitable, the stock must rise above 67.30. That said, when one compares this strategy to owning the shares outright, it seems tempting if only because the maximum loss to the investor is the call option premium which in this case is $2.30.
In conclusion, purchase of RIM shares prior to earnings announcement is risky. Options are a great way for willing participants to maintain a stake in RIM while keeping losses to a minimum.
By the way, a similar strategy could be structured but in reverse for those investors favoring a decrease in the share price. Puts allow the investor to benefit from a price drop rather than a price increase. Bascially, a person expecting a drop in in the stock price could buy puts outright. And like the case with the call option, the put strategy ensures that the maximum loss is no more than the premium paid for the option.
Author: David Kaminker
www.fwcapital.ca
www.frontwater.ca