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Another Good News Is A Bad News Trading Opportunity

Another Good News Is A Bad News Trading Opportunity

The tone of the market seems to be shifting. The first signs of a bearish tone could be the reaction to earnings announcements that seem to be good news. When traders are bullish, they buy good news. When they are bearish, they sell the news because they worry the good news was already priced into the stock.

Over the past few days, there are several examples of selling good news. Market Watch reported,

“Zscaler Inc. ZS, shares dropped even after the cloud-based cyber security company topped Wall Street estimates for both its results and outlook.

ZS daily chart

The company reported a fiscal third-quarter loss of $12.2 million, or 10 cents a share, compared with a loss of $10 million, or 14 cents a share, in the year-ago period. Adjusted earnings were 5 cents a share.

Revenue rose to $79.1 million from $49.2 million in the year-ago quarter. Analysts surveyed by FactSet had forecast earnings of a penny a share on revenue of $74.9 million. Zscaler expects adjusted earnings of a penny to 2 cents a share on revenue of $81 million to $83 million, while analysts had forecast a penny a share on revenue of $78.9 million.

An article at Benzinga noted that at least one analyst was unphased by the selling and remained bullish on the stock:

“Daniel Ives maintained an Outperform rating on Zscaler and raised the price target from $68 to $82.

The Thesis

The global cloud-based information security company reported third-quarter results that were significantly ahead of expectations. Total revenue growth came in at a whopping 61 percent year-on-year, while billings growth of 55 percent crushed Street expectations, Ives said in a [recent] note.

The results highlighted Zscaler’s ability to capitalize on cross- and up-selling opportunities that are likely to drive growth in the fourth quarter and 2020, the analyst said.

Zscaler is at an inflection point, as enterprises worldwide are beginning their cloud migration journey, driving the need for “the highly differentiated security and speed the company has to offer,” he said.

Ives said he expects “massive tailwinds” for the company’s cloud native network security approach through 2020, given the robust quarterly performance, the raised billings outlook for 2019 and Wedbush’s bullish field checks.”

Field checks are an analyst’s efforts to talk to customers and learn what they think of the company’s products including plans for buying.

ZS has been on a bullish tear and could be due for a pull back even if the longer term outlook is as bullish as some analysts believe.

ZS weekly chart

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.

bear call spread

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 ZS

For ZS, we could sell a June 21 $65 call for about $5.50 and buy a June 21 $70 call for about $3.10. This trade generates a credit of $2.40, 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 $240. The credit received when the trade is opened, $240 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $260. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($240).

This trade offers a potential return of about 92% 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 ZS is below $65 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 $260 for this trade in ZS.