A New Risk for Investors to Think About
Investors know that trading is risky. They are aware that the stock market can drop on news, and sometimes without any news. There are a number of reasons for that possibility and many analysts categorize risks as market risks or company specific risks.
Company specific risks are varied. They could be related to earnings, operational performance or even, sometimes, the behavior of a top executive. In small companies, this is known as “key person risk” and in large companies can be seen in the recent market action of JD.com (Nasdaq: JD).
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The CEO Can Become a Risk
The news itself was pretty unusual for a top executive at a multinational company. Reuters reported,
“A U.S. police investigation into an allegation of rape against JD.com Inc CEO Richard Liu has hammered the e-commerce giant’s shares, with the case laying bare risks posed by his iron grip on management and the lack of other leaders to challenge him.
Liu was arrested and then released without charge in the U.S. city of Minneapolis last week. Through his lawyers, he has denied any wrongdoing.
While the tech industry is known for the outsized control that founders like Liu have over their businesses, China’s tech leaders tend to be all-powerful, exacerbating governance risks.
Liu’s control of JD.com in particular has raised eyebrows given company rules that make it virtually impossible for the board to make decisions without him present.
“There is so much more hierarchy and less willingness to challenge the boss and less collective leadership around Chinese iconic leaders,” said James Robinson, managing director in Shanghai for public relations firm APCO Worldwide.
Robinson added this had compounded the sense of crisis and confusion when the news first broke. JD.com’s communications team had stated police had “quickly determined” there was no substance to the claim against Liu even though the investigation was still ongoing, and took almost two days to acknowledge he had been held by police overnight.
“If your top person is in a jail in Minnesota, then it could be a question of a lack of decision-making authority,” he said.
Liu was arrested late last Friday in Minneapolis and held by police for a little over 16 hours before being released. No bail was set. Police are still investigating. His lawyers have said they do not expect charges to be laid.”
In the two days after the arrest, JD.com has lost $7.2 billion or 16 percent of its market value. Analysts noted that there were fears the company could also be hurt by fears that the case will turn customers away from the JD.com website.
Liu owns about 16 percent of JD.com’s stock. But his power is amplified by weighted voting rights that give him nearly 80 percent of the company’s votes and the provision that bars the board from making binding decisions unless Liu is present, either in person or by teleconference, so long as he is a director.
If he is not present, the board can make decisions only with his permission or if he is sick. The clause explicitly excludes this being allowed during “any confinement against his will”, suggesting he could maintain control even in jail.
“We can’t think of any other company that has such articles,” said Jamie Allen, general secretary of the Asian Corporate Governance Association.
“I find it baffling. Liu already has weighted voting rights, so he can control the company, he is the founder. I don’t think any of the board would dare make a decision without him, so why would he need to do this?” said Allen.
JD.com board members did not respond to requests for comment. The company declined to comment on questions concerning governance and its initial response to Liu’s arrest.
The news comes as the stock is already under pressure as the long term chart shows.
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.
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.
A Bear Call Spread in JD
For JD, we could sell a September 21 $27 call for about $1.36 and buy a September 21 $31 call for about $0.16. This trade generates a credit of $1.20, 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 $120. The credit received when the trade is opened, $120 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $280. The risk can be found by subtracting the difference in the strike prices ($400 or $4.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($120).
This trade offers a potential return of about 43% of the amount risked for a holding period that is about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if JD is below $27 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 $120 for this trade in JD.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.