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Chip Makers Might Struggle This Quarter

Chip Makers Might Struggle This Quarter

All eyes are now on earnings and some sectors are expected to fare better than others. Among the sectors that could struggle is the technology hardware industry. Specifically, the chart of the technology, hardware, storage and peripherals industry is shown below.

chart of the technology, hardware, storage and peripherals industry

This industry is down about 40% since the general market decline began in October. It has been a steep fall and there is additional down side risk in the industry. Many technical indicators measuring momentum are still on sell signals and trend analysis continues pointing down.

This leaves the industry as a potential source of bearish trades. While exchange traded funds or ETFs do make it possible to trade an industry group, individual stocks tend to offer better returns than ETFs.

Among the potential trades, as TheStreet reported, is Western Digital (Nasdaq: WDC) which saw its share prices sell off after a critical analyst report says the data storage company may be forced to cut its dividend amid stiff market competition.

“The combination of “free cash flow tracking to ~$2.35 per share” in 2019, combined with Western Digital’s $11 billion in gross debt, poses a “clear risk to the annual dividend of $2 per share,” wrote Evercore ISI analyst C. J. Muse in a report released Monday morning.”

Western Digital’s stock price fell more than 6% on the news and this continued the down trend that has been underway in the stock for the past few months.

WDC daily chart

Analysts Downgrade the Stock

TheStreet  continued, “Evercore cut its rating on Western Digital to “underperform,” with its price target down to $30.

The report also warns of a “sizable reset to earnings” ahead for Western Digital, with Evercore reducing its earnings estimates on the data storage company to $2.92 per share from $4 previously.

“We are hard pressed to see the company’s current dividend as sustainable in the current market. And until investors fully appreciate this reality, we continue to see further downside risk for shares,” Muse wrote.

Western Digital will face a slowdown in demand for HHD, hard disk drive, revenue as well as “worse than modeled” average sell prices on NAND flash products.

Western Digital’s share of the enterprise solid-state drive SSD storage market has declined by half over the past few years to 12% due to “technology roadmap delays” vs. “peers like Samsung,” according to Evercore.

Samsung has doubled its enterprise SSD market share during the same period to 40%, Evercore noted.”

The long term chart of the stock shows that this down trend has been underway since last spring as traders sold ahead of the news.

WDC weekly chart

There is little sign of a bottoming process and traders could consider bearish trades from a resumption of the move down.

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.

A Bear Call Spread in WDC

For WDC, we could sell a February 15 $37.50 call for about $2.55 and buy a February 15 $40 call for about $1.45. This trade generates a credit of $1.10, 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 $110. The credit received when the trade is opened, $110 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $140. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($110).

This trade in WDC offers a potential return of about 78% 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 WDC is below $37.50 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 $140 for this trade in WDC.

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.