A Trading Strategy for an Interesting Chart Pattern
A number of stocks are facing critical points on the charts. An example is seen in the chart of Molina Healthcare, Inc. (NYSE: MOH) below.
This is a chart showing a down trend. The large gap down is a possible indicator of capitulation selling. Investopedia defines this in the following terms:
“Capitulation is when investors give up any previous gains in any security or market by selling their positions during periods of declines. Capitulation can happen at any time, but typically happens during high volume trading and extended declines for securities.
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A market correction or bear market often leads investors to capitulate or panic sell. The term is a derived from a military term which refers to surrender.
After capitulation selling, many traders think there are bargain buying opportunities. The belief is that everyone who wants to sell a stock for any reason, including forced selling due to margin calls, has already sold.
The price should then, theoretically, reverse or bounce off the lows. In other words, some investors believe that capitulation is the sign of a bottom.”
In the chart, we see that there was a small bottom formed after the selloff and now a potential reversal could be near. However, there are risks. To decrease the risks, we can wait for a catalyst to trade and use a strategy that limits risk.
News As A Potential Catalyst
According to ZACKS, Molina Healthcare, Inc. MOH recently announced extending its agreement with CVS Caremark for Pharmacy Benefit Management (PBM) services through 2021. This renewal, effective immediately, followed a comprehensive procurement process.
With this deal, CVS Caremark will continue to administer pharmacy benefits for around 4 million members whom Molina Healthcare serves via its Medicaid, Medicare and Marketplace health plans.
The deal modifies Molina Healthcare’s current contract with CVS Caremark to orient Molina Healthcare’s pharmacy management strategy with better functional measures, which are under process since last year.
The pact is immediately accretive to earnings and will allow Molina Healthcare to stay responsive to its state partner requirements. Notably, the latter controls around $3 billion of the company’s annual pharmacy costs in a growing government-sponsored health care scenario.
It is needless to say that this is another effort by Molina Healthcare to control its expenses that include clinical strategies with formulary, utilization management and generic dispensing initiatives.
In the second quarter of 2017, the company started a comprehensive restructuring and profitability improvement plan to streamline its organizational structure with an aim to improve efficiency as well as the speed and quality of decision-making.
The company plans to reduce annualized run-rate expenses by approximately $300-$400 million by the end of 2018. In the first nine months of 2018, the company incurred $35 million to meet the goals of its 2017 restructuring scheme. As part of this endeavor, the company sold its units —, Pathways Health and Community Support, LLC and Molina Medicaid Solutions — to be able to focus on core growth areas.
The renewed tie-up and the streamlining attempts have helped the company provide better results to its members as well.
The long term chart shows that MOH reached an important support level in the decline and could be near a rebound.
A Trade for Short Term Bulls
As with the ownership of any stock, buying MOH 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 prices stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for MOH
For MOH, the January 18 options allow a trader to gain exposure to the stock.
A January 18 $130 call option can be bought for about $2.80 and the January 18 $135 call could be sold for about $1.15. This trade would cost $1.65 to open, or $165 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 $165.
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 MOH the maximum gain is $3.35 ($135 – $130 = $5.00; $5.00 – $1.65 = $3.35). This represents $335 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $165 to open this trade.
That is a potential gain of about 103% 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.