A Potential Bargain in the Marijuana Industry
Marijuana is booming as the market becomes legal for a product with a long history of demand. The opportunities for entrepreneurs and investors are significant as new markets are rare in the developed economies of the world.
This means there will be rewards to those who buy at the right time although there are still risks in the industry which faces a number of legal hurdles. The potential rewards and risks can be seen in a leader in the industry.
An Earnings Report Creates Volatility
Canopy Growth Corporation (NYSE: CGC) is the world’s largest publicly traded marijuana stock, measured by market capitalization. It is also the first stock from the marijuana industry to be approved for listing on the New York Stock Exchange, one of, if not the, most prestigious exchanges in the world.
The company recently released its first earnings report as a publicly traded company. Although listed on the NYSE, CGC is gearing up to meet demand in Canada where the government will completely legalize marijuana on October 17.
Due to similar legalization efforts in the United States, CGC has significant growth potential in this country as well. NAFTA, the trade treaty that expands opportunities for companies in Canada, the US and Mexico, should allow for rapid expansion to the south as legalization spreads.
The effort to stock up and prepare for that date will be an expensive undertaking and this is reflected in the company’s earnings. CGC reported a loss of $0.40 per share for the past twelve months, significantly higher than the loss of $0.06 per share reported in the previous fiscal year.
The stock sold off sharply on the loss.
Not surprisingly, the loss is because of higher expenses that result from expanding the amount of real estate for growing, investments for growing operations and completing deals to secure access to supply.
The report emphasized the reality of the market which is that investment will be required to meet the demand. There is no doubt that annual sales of marijuana and derivative products will be measured in the billions.
Source: ArcView via Marijuana.com
But, there will be investments that are needed to ramp up to achieve those sales.
This is true for any market and in any industry. The important question for investors will be to find the companies that are likely going to be able to access funds to grow so that they can prosper in the long run.
One indicator that CGC will be among the winners in the long term is the investment of Constellation Brands (NYSE: STZ), Constellation Brands is the third-largest beer company in the US and its brands include Corona, Modelo, and Pacifico. The company also has a portfolio of wines and hard liquors.
STZ invested $190 million in CGC and owns a 9.9% stake. When making the announcement, the company noted that it is working to keep up with “evolving consumer trends and market dynamics, while maintaining focus on its core total beverage alcohol business.”
Recent weakness in CGC is likely to be a buying opportunity. Investors wanting long term exposure to the marijuana industry could consider weakness as a chance to add to positions in the company. Weakness also provides opportunities for short term trades.
In the long run, a series of short term trades could be as profitable or even more profitable than a single long term buy.
A Trade for Short Term Bulls
As with the ownership of any stock, buying CGC could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for CGC
For CGC, the July 20 options allow a trader to gain exposure to the stock.
A July 20 $30 call option can be bought for about $0.85 and the July 20 $35 call could be sold for about $0.30. This trade would cost $0.55 to open, or $55 since each contract covers 100 shares of stock.
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 $55.
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 CGC the maximum gain is $4.45 ($35 – $30 = $5.00; $5.00 – $0.55 = $4.45). This represents $445 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $55 to open this trade.
That is a potential gain of about 709% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.