An Internet of Things Trade
The Internet of things is changing the world, and creating investment opportunities. The Internet of things is defined as “the interconnection via the Internet of computing devices embedded in everyday objects, enabling them to send and receive data.”
This includes driverless cars and refrigerators that allow shoppers to check expiration dates of milk while they are away from home. Generally, consumers think of powerful technologies when they imagine the Internet of things.
Traders have a tendency to do the same. They look at investing in driverless technology through expensive companies like Tesla. The electric car maker has a highly volatile stock that moves largely on pessimism and optimism about production of the cars.
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There will be a number of great technology products introduced in the next few years. There is no doubt about that. Tesla might even be on the list of companies that deliver these great products. There is doubt about that given the company’s history of production delays.
The truth is there is no way to pick the winners and losers of any technology in advance. Tesla may come through, but Ford, BMW and Mercedes Benz have all displayed technologies that incorporate driverless capabilities in their vehicles. Other automakers are hard at work on the technology;
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At times like this, when traders can see phenomenal developments on the horizon but lack clarity as to who the winners and losers will be, it can be useful to think of the story of Levi Strauss. As the company explains:
“When news of the California Gold Rush made its way east, Levi journeyed to San Francisco in 1853 to make his fortune, though he wouldn’t make it panning gold. He established a wholesale dry goods business under his own name.”
It’s a great story that has become a legend. Business schools can shorten the story to the simple idea that “you can mine for gold or you can sell pickaxes and blue jeans.” History shows that in the Gold Rush many of the miners failed to find their fortune.
But, some of the most successful business people were the ones who sold supplies to the miners, people like Levi Strauss who started making tents and eventually made a fortune selling denim pants.
As has often been the case, glamorous jobs like gold mining have a lower return on investment than selling supplies to the workers who need basics to pursue their dreams.
They didn’t mine for gold themselves but instead sold supplies to miners – wheelbarrows, tents, jeans, pickaxes etc. Mining for gold was the more glamorous path but actually turned out, in aggregate, to be a worse return on capital and labor than selling supplies.
The stock is likely to fall into a short term 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.
For the Internet of things, the pickaxes and blue jeans companies might be the chip makers. Traders seem be starting to come to this conclusion and are bidding up the stocks of companies that provide the components to the companies seeking fame and fortune.
Traders interested solely in fortune could skip finding the next big thing and focus on companies like Seagate Technology PLC (NASDAQ: STX).
Seagate is the world’s second largest chip maker. The company recently introduced the first hard disk drive (HDD) created specifically for artificial intelligence (AI) enabled video surveillance.
The SkyHawk AI HDD, which is equipped with Seagate’s ImagePerfect AI firmware, will be marketed to the video surveillance market. It comes in two models, an 8TB model for a list price of $350 and a 10TB model which will sell for $450.
The promise of new technologies has fueled a rally in Seagate’s stock price.
The chip makers are coming out of a bear market that began as they were viewed as commodity providers, simply providing components for smart phones, tablets and servers. Now, the market for chips is expanding and even washers and dryers will require multiple chips to function in the future.
This has led to sharp moves in the stock price of STX in recent weeks as traders react and overreact to each news story and earnings report.
As earnings season winds down, the stock is likely to 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 Seagate Technology
For STX, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, December 15.
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 $0.91 in income ($0.45 from the call and $0.46 from the put). Buying the options will cost $0.60 ($0.30 for the call and $0.30 for the put). This means opening the trade will result in a credit of $0.31, or $31 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 ($0.31). This is equal to $0.69, or $69 since each contract covers 100 shares. Most brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $69 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $0.31, or $31 per contract.
The potential reward on the trade ($31) is 45% of the amount risked, a high potential return on investment for a trade that will be open for less than a month. If a trade like this is entered every month, 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.