After a Great Year, This Stock Could Still Deliver Gains
Investors are always faced with a question after a stock makes a big move. Whether the move is up or down, the question is always, “what’s next?” Of course, this is always the question on the mind of investors looking for profits from what happens next.
That question of what’s next is on the minds of those looking at shares of Micron Technology, Inc. (Nasdaq: MU). Micron is one of the largest memory chip makers but makes just three types of chips known as DRAM, NAND and NOR memory chips.
Demand for these chips has been high and the stock price of MU reflects that fact.
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A Cyclical Industry
We often think of cyclical industries as being stodgy old metals companies that meet demand for economic booms and struggle through downturns. Memory chips are also cyclical. New devices come out and generate demand. Then, demand wanes as consumers wait for the next new device.
These cycles can be seen in the next chart which is a long term view of Micron Technology shares using monthly data.
The current cycle appears to be near a top. Earnings estimates confirm this view. Analysts expect earnings per share (EPS) of $9.74 in the current fiscal year. In fiscal year 2019 which ends in August, they expect EPS of $8.54 followed by EPS of $7.38 in fiscal year 2020.
Based on the current stock price, even if demand for chips has reached a cycle high, MU appears to be undervalued. The price to earnings (P/E) ratio is about 5.8 using the lowest EPS estimates, the analysts’ view for 2020.
But, the cycle might not be peaking this demand. There is an increasing demand for cloud computing and that could lead to continued demand for memory chips in servers that make up the cloud.
Another factor pointing towards continued demand for chips is the growth of the Internet of Things. Smart appliances like refrigerators, dishwashers, thermostats and others all require memory.
These factors all create a sense of confusion about the trend in Micron shares. There are both bullish and bearish factors to consider. Plus, there is extreme value in the stock based on popular fundamental metrics and this could make the stock attractive to bargain hunters in an overvalued market.
A Strategy to Benefit While Waiting for More Details
As we wait for clarity on the impact of these various factors, we could see stocks settle into a trading range. One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in Micron Technology
For Micron Technology, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, January 19.
The difference in the exercise prices of the calls or puts is equal to $1.00. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $100 less the premium received when the trade was opened.
Selling the options will generate $0.54 in income ($0.32 from the call and $0.22 from the put). Buying the options will cost $0.29 ($0.17 for the call and $0.12 for the put). This means opening the trade will result in a credit of $0.25, or $25 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($1.00) minus the premium received ($0.25). This is equal to $0.75, or $75 since each contract covers 100 shares. Many brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $75 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $0.25 or $25 per contract.
The potential reward on the trade ($25) is about 33% of the amount risked, a high potential return on investment for a trade that will be open for about one week. If a trade like this is entered every week, a small trader could quickly increase the amount of capital in their trading account.
The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.
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.