7 Stocks You Need to Watch This Earnings Season

Earnings season provides a good opportunity for fundamental investors to track the state and progress in the underlying businesses in which they are shareholders. However, earnings announcements also present certain risks that investors should be aware of. Below, I'll highlight seven stocks that could exhibit greater volatility than the average as well as strategy to manage that risk.

Premium valuation + earnings uncertainty = A recipe for negative surprise
The stocks in the following table all sport premium valuations compared to their industry peers and high variability in analyst estimates. Furthermore, they have an EQ score that is average or below-average. (The EQ score is part of an earnings quality model developed by The Motley Fool's John Del Vecchio to identify potential "short" candidates. Companies with low quality of earnings typically underperform the market.)

Source: Capital IQ, a division of Standard & Poor's, The Motley Fool, Yahoo! Finance.

A high variability of estimates around the consensus suggests there is a greater likelihood of an earnings surprise (positive or negative). If a stock is already fully valued or -- perish the thought -- overvalued, a negative surprise can produce an immediate and painful revaluation.

Put a collar on those shares!
One way to mitigate that downside risk is to put a collar on the shares you own. Imagine that you've owned Apple shares in your portfolio for several years, and you're concerned about protecting your accumulated profits on the position. In order to do so, you purchase a January 2012 put option at a strike price of $300. That put gives you the right to sell those shares at that price on or before the option expiration date, thereby capping any potential loss at 12%.

In order to offset the cost of the put, you simultaneously sell a January 2012 call option with a $400 strike price, thereby selling someone the right to acquire the shares should they reach that level. The net cost of this insurance: $2.40 per share, or roughly three-quarters of a percent of the value of your position. In establishing the collar, you are trading some of the upside on your stock position to limit your downside risk. Your upside and downside returns are contained -- thus the name "collar."

A real-world example
Motley Fool Pro likes medical technology company Kinetic Concepts -- it's the second-largest position in Pro's $1.4 million portfolio, and the team continues to rate the stock a buy. However, last October, Pro advisor Jeff Fischer was concerned that, on the back of several disappointments, a negative third-quarter earnings report could leave the stock wounded. In order to protect the position, Jeff put on a collar that actually generated income for the portfolio -- he received more for the calls he sold than he paid for the puts. His fears proved unwarranted, but why pass up no-cost insurance?

Be wary of "sure thing" earnings
Investors in stocks in the above table aren't the only ones who might want to consider a collar strategy. Indeed, while a wide spread in analyst estimates indicates a broad range of opinion concerning a company's operating performance, an excessively narrow spread could indicate complacency or groupthink among the analysts that cover the stock. In this case, an earnings miss or similar disappointment can hammer a stock. Here are two stocks whose valuations look stretched, and on which analysts seem in near-complete agreement regarding last quarter's results:

Source: Capital IQ, a division of Standard & Poor's, The Motley Fool, Yahoo! Finance.

By mentioning specific names, I'm not trying to shake out long-term investors. If you're convinced of your thesis regarding any of these stocks, there is no call for rash action on this basis. However, even patient, fundamental investors need to be aware that the right strategies to manage short-term risks can materially improve a portfolio's long-term returns.

Your next step to a better managed portfolio
If you're interested in finding out more about option strategies that could help you reduce the downside risk to your portfolio and add to your overall returns, drop your email in the box below. In return, Jeff Fischer will send you his free report, How to Profit From the One "Sure Thing" Coming in 2011, along with an individual invitation to join Motley Fool Pro, which is open to new members for a short time. These strategies could put your portfolio at an advantage in what is shaping up to be a very tricky market to navigate.