A Big Decline Could Be the Start of a Big Loss
Traders often focus on mean reversion strategies. The idea of a mean reversion strategy is that a sudden, large move in a stock price will be at least partly reversed in the short run. In other words, the price move back towards its average value, or revert to the mean.
It’s a popular strategy and many hedge funds have used mean reversion strategies with some success. For individual investors, the record of success might be mixed. This is because mean reversion is a general tendency and can deliver profits, on average, in the long run.
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Hedge funds will employ the strategy every day, among dozens or even hundreds of stocks. They are pursuing small gains on a large number of winning trades and accepting large losses on a small number of trades.
Individual investors lack the resources to make that many trades. This means the losing trades will have a large impact on their account.
Rather than assuming a large drop will be followed by mean reversion, traders can decrease risks by assuming the move could be the start of a trend. This could be the case when bad news hits.
Bad News Swarms Symantec
Symantec (Nasdaq: SYMC) fell after the company announced that it was looking into unspecified financial issues and warned it may have to amend financial results and guidance and will likely miss a regulatory deadline.
The company noted that it opened an internal probe and notified the Securities and Exchange Commission after a former employee raised some concerns. This was included in its latest earnings report.
The stock fell sharply on the news.
Analysts responded by cutting expectations. At least five analysts downgraded their ratings on Symantec’s stock, according to FactSet, and MarketWatch counted one more who was not in FactSet’s database.
Just four of the 30 analysts who cover the stock rate it a buy, while 23 rate it a hold and three call it a sell, according to FactSet.
Typical of the analysis was this comment from BTIG analyst Joel Fishbein, who downgraded the stock to neutral from buy, noting, “The fog created by an internal investigation of the company led by the audit committee of the board, with no semblance of detail provided to investors, overshadows everything else in Thursday’s Q4 and FY 2018 earnings.”
The stock is now at its lowest level in nearly two years.
With analysts’ bearishness, a recovery seems unlikely in the short term.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a short term rebound in SYMC seem to be remote. Traders should consider using an options strategy known as a bear put spread to benefit from the expected downward 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 option trading ideas 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 SYMC
The bearish outlook for SYMC, 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 June 15 $21 put can be bought for about $2.40 and the June 15 $20 put can be sold for about $1.70. This trade will cost about $0.70 to enter, or $70 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 spent to open the trade, or $70. This loss would be experienced if SYMC is above $21 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 SYMC, the maximum gain is $0.30 ($21 – $20 = $1.00; $1.00 – $0.70 = $0.30). This represents $30 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $70 to open this trade.
That is a potential gain of about 42% of the amount risked in the trade. This trade delivers the maximum gain if SYMC closes below $20 on June 15 when the options expire.
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 $70 for this trade in SYMC.