Tim Hortons Earnings Follow Up

Back on October 15th, I wrote about some unusual activity on Tim Hortons options that caught my eye earlier in the week. At the time, I hypothesized that a trader may have created a position to take advantage of the earnings report scheduled to be released on November 7th. While I will provide a brief review of the strategy below, you can read the full post here Tim Hortons Serves Up Some Unusual Activity

On October 9th, Tim Hortons (TSE:THI) shares closed at $59.70. On that day, there were over 2000 November 62 and 64 strike calls traded as well as 500 each of the November 56 and 54 strike puts. I will caution, as I always do, that it is difficult at best to determine exactly the intention of the trader or traders as there is no indication as to whether these contracts were purchased or written, or whether they were all part of the same strategy. With that in mind, I suggested that an advanced options trader could create a bullish position at a reduced cost by purchasing a Bull Call Debit Spread. To reduce the cost even further, a Bull Put Credit Spread could also be executed.

With the shares at $59.70, the Bull Call Spread would be constructed as follows:

• Buy the November 62 strike calls and pay $0.65
• Sell the November 64 strike calls and collect $0.28
• Net debit = $0.37
• Max profit = $1.63 ($2.00 spread minus the premium)
• Break even on expiration = shares at $62.37

Assuming 2000 spreads were executed, this would be a cost of $74,000.00 for a profit potential of $326,000.00

The Bull Put Spread would be constructed as follows:

• Sell the November 56 strike puts and collect $0.35
• Buy the November 54 strike puts and pay $0.19
• Net credit = $0.16
• Max Risk = $1.84 ($2.00 spread minus the premium collected)
• Break even on expiration = shares at $55.84 (56 strike minus premium collected)

Assuming that 500 spreads were executed, a credit would be received of $8000.00, but an additional risk of $92,000.00 is added.

All things considered:

The cost of the combination would be the $74,000.00 debit – $8000.00 credit = $66,000.00

The risk is increased due to the Credit Spread and is determined to be:

$74,000.00 ( debit)
+ $ 92,000.00 (credit spread differential minus credit)
= $166,000.00

This would be incurred if the shares are below $54.00 on expiration.

So, we can assume that the maximum risk on the trade is $166,000.00 for a maximum profit potential of $326,000.00

Earnings release

Tim Hortons released earnings on November 7th and Judy McKinnon of the Wall Street Journal reports:

• Third-quarter profit climbed 7.5% on stronger overall revenue and same-store sales growth in both Canada and the U.S.62
• Stronger results came despite what it said was a challenging operating environment.
• Same-store sales in the U.S. were up 3.0%, while Canadian same-store sales rose a more muted 1.7%.
• Earnings climbed to 115 million Canadian dollars ($110.4 million), or 75 Canadian cents a share, from C$107 million, or 68 Canadian cents a year earlier.
• Results in the latest quarter were hurt by a C$2.9 million asset-impairment charge related to under performing markets in the U.S. Year-earlier results included C$8.6 million of corporate reorganization expenses.
• The Thomson Reuters mean estimate was for a profit of 77 Canadian cents a share.
• Revenue rose almost 3% to C$825.4 million. Analysts were expecting revenue of C$824 million.

Shares rallied into the earnings release, however despite positive numbers, TSE:THI pulled back from a high of $63.86 on October 28th to settle at $62.55 this past Friday, November 8th.

With earnings behind us, there are a few important trade management considerations. Since expiration is next week, there is significant risk that the shares may continue to drift lower devaluing the Bull Call Spread. It would be wise for the trader to lock in profits or risk losing them.

As indicated above, the original debit was $0.37. A look at the closing prices on Friday reveal the 62 strike call bidding $0.68 and the 64 strike asking $0.08. Based on these values, the spread could be closed at $0.60 for a 62% gain.

It should be noted that prior to the earnings report, TSE:THI traded at a high of $63.86. Regardless of the intention to play the earnings, a prudent trader would look at an opportunity to lock in profits ahead of the announcement as a good risk management decision. Clearly, it is not likely that the trader is going to pick the exact high before the earnings, but for the sake of this example, with the stock hitting $63.86 on October 28th, the 62 strike was bidding at $1.99 and the 64 strike calls were asking $0.88. The spread on this date could be offset for $1.11 representing a 200% return.

What about the Credit Spread?

You will recall we made an assumption that a Bull Put Spread was constructed as part of this combination. The intention being to bring in some additional premium to help offset the cost of the trade. With the shares trading above the November 56 strike written as part of the credit spread, the options have a high probability of expiring worthless. In this scenario, the trader can keep an eye on the share price for the remaining week and buy the spread back only if the 56 strike is in jeopardy of expiring in the money.

Assuming that this was indeed the strategy executed, the trader has managed to meet their objectives and is now in a position of profitability. The bullish directional position was created with a limited and identifiable risk. While the intention may have been to hold the trade through earnings, if the position is profitable prior to, it is often best to consider closing a portion, if not all of the position. As history has taught us, earnings can surprise, and not always in the direction anticipated.