Bear Market Jitters Tank Some Potential Winners
Traders are on edge and it’s easy to understand why. The bull market began in March 2009 and is now more than nine years old. Eventually, there will be a bear market and every day that passes brings traders one day closer to the inevitable market decline.
Economic good news is starting to become a concern as well. The unemployment rate is now at what appears to be a level likely to cause inflation. There are fewer and fewer unemployed in the economy and attracting new workers or retaining existing workers could require wage increases.
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The Federal Reserve is likely to continue raising rates as they have been. In the past, the Fed has continued raising rates once they started until the economy tips into recession. It’s possible this time is different but many traders are watching for signs of a recession.
An Understandable Response to News
In this environment, traders are focused on avoiding the large losses that can come in a bear market. This means they are often selling stocks they believe could be among the hardest hit when stocks do decline.
Among those stocks is Virtu Financial, Inc. (Nasdaq: VIRT). The company is a high frequency trading firm that operates as a market maker in the financial markets. VIRT’s systems generally trade ahead of other orders, allowing the firm to generate small but consistent profits on millions of trades a day.
In the most recent quarter, the firm reported earnings per share (EPS) of $0.76, after various accounting adjustments. Analysts had been expecting EPS of just $0.61, on average.
The acquisition of KCG, the trading firm it bought in 2017, gave its numbers a lift as did favorable market conditions, according to chief executive Doug Cifu.
“Our continued successful integration enabled this quarter’s outstanding performance in this favorable environment,” Cifu said. “The first quarter of 2018 saw the return of volume and volatility.”
Despite the strong financial performance, the stock sold off on the news.
Analysts attributed the sell off to comments the CEO made during the conference call that accompanies the earnings release.
Cifu noted that the current environment in the second quarter, so far hasn’t sustained the first quarter’s averages for realized volatility, though “it does remain decidedly better” than the last half of 2016 and all of 2017.
Later in the call, management added that Asian markets in general, and Tokyo share volumes in particular, were down approximately 7% in the first quarter.
The Longer Term Picture Is Bullish
Prior to the earnings related selloff, VIRT had been among the market’s top performers. As the chart below shows, the stock may have gotten ahead of itself and the recent decline relieved the overbought extremes of the stock. Now, the stock may have support near the recent lows.
In addition, the selling pushes the stock towards an area where value investors could be enticed into buying. The stock is now trading at about 15 times next year’s expected earnings, a relative bargain for a growth stock in the current market environment.
It’s likely VIRT will recover as traders recall that market makers like VIRT will continue to trade even in a bear market. VIRT’s business, in some ways, is immune to the market cycle since traders will always need someone on the other side of their orders.
That means a put selling strategy could generate low risk income in the stock.
Trading the Trend
When a stock is expected to move higher, traders could consider obtaining long exposure to the stock to profit. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread that could be used. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which is in an up trend.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
A Specific Trade for VIRT
For VIRT, a bull put spread could be opened with the May 18 put options. This trade can be opened by selling the May 18 $30 put option for about $0.35 and buying the May 18 $25 put for about $0.10.
This trade would result in a credit of $0.25, or $25 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $5 ($30 – $25). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $475 ($500 – $25).
The potential gain is about 5.3% of the amount of capital risked. This trade will be for about two weeks and the annualized rate of return provides a significant gain.
The bull put spread 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 could be lower than owning the stock. This strategy also has a high probability of success.
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.