A Tech Company Disappoints Traders and Sets Up a Trading Opportunity
Tech stocks are among the most volatile in the market and that volatility can lead to unusually profitable trading opportunities. A recent opportunity arose after an earnings report fell short of expectations. According to The Street,
“Shares of Dropbox Inc. (Nasdaq: DBX) [sold off] after the file sharing and storage company issued disappointing operating margin guidance during its fourth-quarter earnings call.
The company reported a fourth-quarter loss of $9.5 million, or 2 cents a share, compared with a loss of $37 million, or 19 cents a share, a year ago. Adjusted earnings came to 10 cents a share, up from 3 cents a share a year ago, and beat analysts’ expectations of 8 cents.
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Revenue grew 23% to $375.9 million, above estimates of $370 million.
For the year, the company reported a loss of $484.9 million, or $1.35 a share. Revenue was reported at $1.39 billion.
For the first quarter, Dropbox said it expects $379 million to $382 million in revenue, while analysts are expecting $377 million. For the full year, the company forecasts $1.63 billion to $1.64 billion in revenue. Wall Street is calling for $1.60 billion.
Dropbox said it expects operating margins to be 7% to 8%, excluding certain items, in the first quarter, while analysts are forecasting 12.1%. Full year 2019, Dropbox said it sees an operating margin of 10.5% to 11.5%, below analysts’ estimate of 13.4%
Chief Financial Officer Ajay Vashee said during a conference call with analysts that the company’s first quarter operating margin “is seasonally lower each year and that’s really due to higher employee-related costs like the reset of payroll taxes.”
Last month, the company said it would buy electronic signature company HelloSign for $230 million in cash.
“I will say looking ahead we expect the impact from HelloSign-related investments as well as the overlapping rent expense that I talked to for our existing and new corporate headquarters to decrease in the second half of the year and for us to resume our trajectory of year-over-year operating margin expansion as we exit 2019,” Vashee said.
DBX has struggled since it began trading last March and the chart below shows the price is challenging its all-time lows again.
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.
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 DBX
For DBX, we could sell an April 18 $24 call for about $1.60 and buy an April 18 $27 call for about $0.47. This trade generates a credit of $1.13, 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 $113. The credit received when the trade is opened, $113 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $187. The risk can be found by subtracting the difference in the strike prices ($300 or $3.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($113).
This trade offers a potential return of about 60% 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 DBX is below $24 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 $187 for this trade in DBX.