A Reliable Strategy for Large Cap Disappointments
Options are a versatile tool and there are dozens of strategies available to traders. Yet, many traders find that just a few strategies will deliver profits for many trading opportunities. For large cap stocks, one of the most widely used strategies could be the bear call spread.
This strategy works well after a stock drops sharply. There are several reasons for this but look at an example of how the trade can be implemented. First, find the stock that dropped and understand the reason or the drop.
Qualcomm Gets Some Bad News
Qualcomm Inc (Nasdaq: QCOM) sold off sharply after reports indicated Apple Inc (AAPL) was considering dropping Qualcomm’s modem chips in iPhones and iPads starting with models produced next year.
Qualcomm has been delivering these chips to Apple for years but the relationship between the two companies has long been strained. Apple believes they pay too much for the technology Qualcomm provides.
Earlier this year, Apple accused Qualcomm of overcharging for chips. Apple also accused Qualcomm of refusing to pay about $1 billion that Apple believes Qualcomm promised as rebates. The fact that Apple looking at dumping Qualcomm is a logical step in this battle.
In fact, this could all be part of Apple’s negotiation strategy. “The change would affect iPhones released in the fall of 2018, but Apple could still change course before then, two people familiar with the matter told Reuters on Monday.”
No matter what, the news looks to be a sign of reduced profits for Qualcomm. Apple has already been moving away from Qualcomm, or at least reducing the cost of chips obtained from the company. This has been done by introducing competition.
Analysts have estimated Qualcomm provides only about half of the modem chips that Apple uses in its newest iPhones. The remainder of the chips, a crucial component in the handset, are obtained from Intel which has been improving the quality of its chips in recent years.
Analysts believe the impact on Qualcomm is not a death knell for the company. “Qualcomm’s share represents about $1.5-1.75 billion in annual revenue,” Raymond James analyst Chris Caso said. That estimate is less than a tenth of Qualcomm’s 2016 revenue of $23.55 billion.
These chips represent an estimated $245 million in profits for the company. This is about 5% of Qualcomm’s profits in the last full fiscal year.
These amounts are small, in the large income statements of the two companies, but the stakes are high. If Apple succeeds in this battle, it could go after the royalty revenue paid to Qualcomm. That’s where Qualcomm generates the bulk of its revenue and profits.
If any company wants to sell a phone capable of connecting to the internet at high speeds, they need a license from Qualcomm for one its thousands of patents. The company charges a royalty of as much as 5% of the average selling price of the phone, which can come to more than $50 per device.
Apple negotiated a rebate that dropped that fee to an estimated $10 a phone but recent regulatory actions have led Qualcomm to go back on that deal. That’s led to the recent high stakes battle.
Qualcomm Suffers More Than Apple
The stock chart of Qualcomm shown below indicates that concerns over Apple are weighing on the stock.
The stock price peaked in May 2014, more than three years ago. The downtrend has been accelerating this year.
Traders seem to be confident that Qualcomm’s business model is changing. The latest news, that Apple will be dropping Qualcomm as a supplier, would seem to confirm that news. In the long run, if Apple moves to Intel then other phone providers may do that as well.
These events place a significant portion of Qualcomm’s revenue and profits at stake in the long run. It is likely Qualcomm will survive this problem, but the company could contract over time. The current downtrend seems likely to continue until Qualcomm brings some good news to the table.
That means a decline, or at least a trading range in the stock is likely for at least the short term.
Trading the Trend
To benefit from weakness, an investor could buy put options. But, as the chart shows, MO has been in a downtrend and that has resulted in increased volatility. The higher volatility increased options premiums even more. This is normal behavior when a sell off occurs.
But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility. In this case, with a bearish outlook, a call option should be sold.
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 is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in QCOM
For QCOM, we have a number of options available. Short term options allow us to trade frequently and potentially our account size quickly.
In this case, we could sell a November 17 $53 call for about $2.60 and buy a November 17 $55 call for about $1.50. This trade generates a credit of $1.10, which is the difference in the amount of premium for the call that is sold and the call. Since each contract covers 100 shares, opening this position results in immediate income of $110.
The credit received when the trade is opened, $110 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $90. The risk is found by subtracting the difference in the strike prices ($200 or $2.00 time 100 since each contract covers 100 shares) and then subtracting the premium received ($110).
This trade offers a return of more than 120% for a holding period that is less than three weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if QCOM is below $53 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 $90 for this trade in QCOM.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.