Big News From a Big Name Provides a High Probability income Opportunity
High probability income opportunities are trade set ups that we believe have a better than average potential to provide significant income, on a percentage basis, in a short amount of time.
By focusing on the short term, we maximize the probability of success by selecting stocks that are unlikely to make large moves. This short term focus also provides the opportunity for rapid compounding of gains.
Like many of our trading opportunities, this one is a large cap company that reported earnings. 3M Co. (NYSE: MMM), the company is best known for making Post-it notes but also makes industrial coatings and industrial ceramics reported revenue of $8.28 billion, topping analysts’ $8.08 billion expectations.
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Earnings for the quarter totaled $2.50 per share, matching Wall Street’s expectations.
But, the stock sold off after the company lowered its earnings guidance for the full year. Management told investors to expect earnings per share to come in between $10.20 and $10.55. This was down from the previous range of $10.20 and $10.70 per share.
Analysts Are Split on the News
According to MarketWatch, some analysts are bullish after the news while others are bearish.
Morningstar analyst Keith Schoonmaker notes that the company has a wide moat, a term favored by Warren Buffett to describe a company’s competitive advantage, and that moat should help 3M “navigate a challenging industrial environment.”
The company’s moat prevents a significant downturn, in his opinion, because consumables represent about 50% of 3M’s sales and a “short-cycle recurring revenue stream that contrasts sharply with the long-cycle large-scale equiMMMent sold by industrial peers.”
Analysts at William Blair are also bullish, writing, “We believe 3M is better positioned today than at any time in its recent history.”
On the other hand, Stifel analysts lowered earnings estimates earlier this month citing “global trade risk (North Korea, China trade war, Brexit, Russia), and “commodity material inflation” risks.
The Market Reaction Was Swift
As is common, the stock price moved sharply after the news was released. The stock opened sharply lower.
The long term chart shown below confirms the weakness. The stock had been in a multiyear up trend but the price action of the past few weeks has undercut important support.
Weakness, on both the long term and short term charts, is unlikely to be reversed. Even after the selling, the stock is richly valued trading at a premium to its historic average valuation ratios. MMM is also among the most expensive stocks in its industry group.
The high valuation makes it unlikely that bargain hunters will jump into the stock after the sell off. They are likely to wait for a steeper sell off. This indicates further down side is possible. But, from a trading perspective, the lack of meaningful up side potential creates a profit opportunity.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook for at least the short term, a call option should be sold.
Selling options can involve a great deal of risk. If the stock moves against the position, a large loss could quickly develop. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in MMM
For MMM, we have a number of options available. Short term investment options allow us to trade frequently and potentially our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell an May 18 $210 call for about $2.00 and buy an May 18 $215 call for about $0.60. This trade generates a credit of $1.40, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $140. The credit received when the trade is opened, $140 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $360. The risk is 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 ($140).
This trade offers a potential return of about 38% of the amount risked for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if MMM is below $210 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 $360 for this trade in MMM.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.