This Could Be the Most Overvalued Stock in the Market Right Now
Many researchers have found that investment strategies based on value can work in the long run. The researchers have published results using various metrics, including the price to earnings (P/E) ratio, price to book (P/B) ratio and other fundamental ratios.
Papers on this topic generally follow a similar procedure. The researchers sort all stocks by the metric being studies, the P/E ratio for example. They then create a portfolio that simulates owning the most undervalued stocks, or the ones with the lowest P/E ratio in this example.
The researchers also generally create a second portfolio of the most overvalued stocks, which would be the ones with the highest P/E ratios. These stocks will be grouped in a portfolio of stocks that are assumed to be sold short.
When an investor sells a stock short, they are selling a stock they do not own. To complete the transaction, they borrow shares of the stock from their broker. This loan will eventually need to be repaid. To do that, the trader will buy the shares of the stock they sold earlier.
The goal of a short trade is to profit from a decline in value. Since the stock is sold first, the trader makes money if they are eventually to buy the shares at a lower price.
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In the research papers on value, the researchers will usually report results showing the difference in performance in the two portfolios. Ideally, the undervalued stocks will rise in value and the overvalued stocks will decline in value. Many studies show this type of behavior.
The Problem of Selling Short
While researchers have found the strategy of shorting overvalued stocks can be profitable, there are several issues that individual investors should consider before shorting stocks. In fact, the mechanics of the trading process can occasionally make it impossible for individuals to profit from short positions.
One problem is the cost of a short position. Traders have to complete these transactions in margin accounts and an adverse move in the position (which would be an increase in the value of the stock) could increase the margin requirement. This would generate a cost for interest on the margin loan.
There is also a cost to borrow the stock. This varies from stock to stock and even from hour to hour. The cost to borrow is based on your brokers ability to borrow the shares. This cost can be as little as a few percentage points to more than 100% a year. Traders pay the annualized rate for each day they are short.
Finally, there is the cost of any dividends paid while the position is open. An amount equal to the dividend will be deducted from a trader’s account whenever a dividend is paid.
There is also the risk that a broker will demand immediate repayment of the shares. This is called a “short squeeze” and can happen at any time, in any stock. The trader is then forced to buy the shares at the market price, even if there is a large loss.
The Most Overvalued Stock in the Market Is…
Despite the risks, selling short can be profitable. However, there is no need to accept the risks. A number of options strategies can be used to benefit from a potential decline. To explain this process, we have an example.
To find the most overvalued stock, we used a simple and free screening tool at FinViz.com. We added liquidity filters and the sorted by the P/E ratio, from the highest value to the lowest. The screen is shown below.
This screen showed that Eros International Plc (EROS) when we ran the screen. Eros coproduces, acquires, and distributes Indian films in various formats worldwide. The stock is overvalued even after falling sharply from its highs.
A Trading Strategy to Benefit From Potential Weakness
Because of the stock’s overvalued position, traders should consider using an options strategy known as a bear put spread to benefit from the expected price move.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for EROS
The bearish outlook for EROS, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the December 15 $12.50 put can be bought for about $0.70 and the December 15 $10 put can be sold for about $0.25. This trade will cost about $0.45 to enter, or $45 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spend to open the trade, or $45. This loss would be experienced if EROS is above $12.50 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in EROS, the maximum gain is $2.05 ($12.50 – $10 = $2.50; $2.50 – $0.45 = $2.05). This represents $205 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $45 to open this trade.
That is a potential gain of about 355% on the amount risked in the trade. This trade delivers the maximum gain if EROS closes below $10 on December 15 when the options expire. There is a relatively low probability of that according to the options pricing models. That indicates the gain is likely to be less than the maximum possible gain.
Put spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $45 for this trade in EROS.