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A Downgrade Sets Up a Possible Gain

A Downgrade Sets Up a Possible Gain

Stock market traders often look at analyst ratings. That is important because an analyst upgrade can send a stock’s price higher. In a similar manner, an analyst downgrade could send a stock price lower. But other analysts also follow many companies and their ratings can also affect a stock’s price.

In addition to issuing stock, many companies also issue debt. In fact, standard financial theories dating back to the writings of Ben Graham, encouraged companies to issue debt. The issuance of debt can boost a company’s financial leverage and that can lead to higher earnings for equity investors.

There is a tipping point where debt shifts from a positive to a negative on a company’s balance sheet. That means analysts also follow debt instruments and the ratings on these securities can affect the price of debt and equity since investors understand the link between the two products.

An example of how changes in debt ratings can affect equity prices can be seen in the chart of Sinclair Broadcast Group, Inc. (Nasdaq: SBGI). The recent decline came after an analyst report.

SBGI daily chart

Sinclair  is a television broadcasting company in the United States that owns or provides various programming, operating, sales, and other non-programming operating services to television stations.

Moody’s downgrades Sinclair’s secured debt rating to Ba2. The downgrade of the senior secured instruments reflects the increase in the quantum of senior secured debt and the reduction in senior unsecured debt ranking behind it.

After the transaction, Sinclair will have around $2,625 million of senior secured debt ranking ahead of $1,800 million of senior unsecured notes.

The downgrade comes amid a flurry of other events for the company. PR Newswire reported,

“The company released preliminary Media Revenues for the three months ended June 30, 2019 of approximately $721 million, which is in line with the Company’s previously released outlook of $716 million to $725 million.

The company also announced that it has entered into a multi-year agreement with Charter Communications, Inc. for the continued carriage of the company’s broadcast television stations and Tennis Channel, as well as carriage of Marquee Sports Network when it launches in the first quarter of 2020.

The agreement also provides for a term extension for the carriage of currently carried FOX regional sports networks (the “RSNs”) that is effective upon the Company closing on its pending acquisition of the RSNs from the Walt Disney Company.”

The news comes as the weekly chart shows a potential topping pattern.

SBGI weekly chart

A Trading Strategy To Benefit From Weakness

A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.

In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.

Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.

One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.

Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.

The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.

bear call spread

Source: The Options Industry Council

While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.

You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.

Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.

When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.

A Bear Call Spread in SBGI

For SBGI, we could sell a Sep 20 $50 call for about $5.15 and buy a Sep 20 $55 call for about $2.35. This trade generates a credit of $2.80, which is the difference in the amount of premium for the call that is sold and the call.

Remember that each contract covers 100 shares, opening this position results in immediate income of $280. The credit received when the trade is opened, $280 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $220. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($280).

This trade offers a potential return of about 127% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if SBGI is below $50 when the options expire, a likely event given the stock’s trend.

Call 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 $220 for this trade in SBGI.