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Big Acquisitions Spark a Sell Off and an Opportunity

Big Acquisitions Spark a Sell Off and an Opportunity

VMware, Inc. (NYSE: VMW) shares tumbled [recently] after the company reported a mostly in-line second quarter and announced two big acquisitions, as Benzinga reported. This set up a potential trade.

VMW daily chart

In addition to the highly-anticipated $2.7 billion deal for Pivotal Software Inc (NYSE: PVTL), VMware also took the market by surprise by announcing a $2.1 billion acquisition of security software company Carbon Black Inc (NASDAQ: CBLK), which had been the subject of buyout rumors for weeks.

Several analysts have weighed in on VMWare following its earnings report and news of its spending spree. Here’s a sampling of what they’ve had to say.

Deals Overshadow Solid Quarter

Wedbush analyst Daniel Ives said both of the acquisitions make sense for VMWare and should ultimately increase the company’s SaaS and hybrid cloud subscriptions by more than $3 billion.

“For FY2Q, VMW reported a solid quarter that featured growth in all 3 geographic categories with total revenue growing 12% y/y but will be overshadowed by the license revenue outlook for the remainder of the year/FY3Q20 which was ~$50 million below the Street,” Ives wrote in a note.

BMO Capital Markets analyst Keith Bachman said the buyout deals overshadowed what was otherwise a solid quarter.

“We had previewed that we thought the quarter would be in line and we think the Q was a bit better than we had anticipated,” Bachman wrote.

Acquisitions Make Sense

Raymond James analyst Michael Turits said VMWare is reporting and guiding for some impressive growth numbers given the difficult backdrop, and it’s buyout deals make financial sense.

“While these are large, but not transformative deals, they are logically incremental to VMWare’s container/appdev and security strategies respectively and were made at reasonable valuations,” Turits wrote.

KeyBanc analyst Alex Kurtz said VMWare’s surprise buyout deals and management’s updated long-term strategy may create some uncertainty among investors about whether or not the company is best using its funds.

“Our key takeaway from the two acquisitions is VMware’s intent to modernize and better secure the Company’s core franchise in compute (vSphere),” Kurtz wrote.

But traders do seem to question the deals as the stock’s trend shows.

VMW 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 VMW

For VMW, we could sell an October 18 $130 call for about $10.02 and buy an October 18 $135 call for about $7.70. This trade generates a credit of $2.32, 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 $232. The credit received when the trade is opened, $232 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $268. 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 ($232).

This trade offers a potential return of about 86% 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 VMW is below $130 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 $268 for this trade in VMW.