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This Company Can Win Big in a Market Downturn

This Company Can Win Big in a Market Downturn

As we all know, stock prices will go up and down. While many traders make money only if they can correctly forecast the direction of the trend, there are some companies that make money no matter which way prices move.

As we all know, stock prices will go up and down. While many traders make money only if they can correctly forecast the direction of the trend, there are some companies that make money no matter which way prices move.

Years ago, these traders were the market makers. A market maker was the individual who stood on the floor of the exchange and guaranteed all investors they could buy or sell shares of a company at any time. For this guarantee, they were allowed to earn the difference between the bid and the ask.

The bid is the price a trader is willing to pay to buy a stock. The ask is the lowest price a seller is willing to take. Years ago, stocks traded in fractions and the difference in the two could be an eighth or a quarter. That’s $0.125 or $0.25 per share.

Market makers were guaranteed to make that much money on every share traded as long as they avoided risk. They would avoid risks using options traded under the put call parity formula and being a market maker was very profitable most of the time.

It was maybe a little too profitable and regulators eliminated fractions. The spread between the bid and ask is now a penny or even less. Profits are smaller, and computers replaced individuals on the floor of the exchange. Those computers are now operated by high frequency trading firm, or HFTs.

Big Profits from a Penny a Share, or Less

One HFT went public in 2015, Virtu Financial, Inc. (Nasdaq: VIRT). In regulatory filings required to complete the initial public offering, the company showed a chart of their profitability.

net trading income

Source: SEC S-1 filing

As the company noted, he chart “illustrates our daily Adjusted Net Trading Income from January 1, 2009 through December 31, 2013. As a result of our real-time risk management strategy and technology, we had only one losing trading day during the period depicted, a total of 1,238 trading days.”

Bloomberg reported on that day the firm lost money: “The aberration happened when it missed a special dividend payment for a stock, throwing off its model and causing a seven-figure loss.”

The company still manages its business the same way, looking for small gains of maybe $1 or less on thousands of trades a day.

Earnings Confirm the Business Model Works

This week, Virtu reported fourth quarter earnings of $25.4 million, or $0.22 a share, nearly double analysts’ expectations of about $0.12 a share.

Douglas Cifu, the company’s Chief Executive Officer noted, “In our first complete quarter after the acquisition of KCG, the combined Virtu franchise continues to outperform. The $3.8 million per day we earned in Adjusted Net Trading Income in the fourth quarter demonstrates that this combined entity can generate profitable results in a variety of market operating environments.”

Looking ahead, he added, “We also remain confident that the expense and efficiency discipline that is a hallmark of Virtu is being applied to the legacy KCG businesses, and the synergy results reported today and expense guidance we have provided demonstrate this discipline.”

The company could do even better with increased volatility since volatility can trigger additional trading activity and wider spreads.

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 trading 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.

bull put spread

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 March 16 put options. This trade can be opened by selling the March 16 $20 put option for about $0.50 and buying the March 16 $17.50 put for about $0.10.

This trade in VIRT would result in a credit of $0.40, or $40 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 $2.50 ($20 – $17.50). 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 $210 ($250 – $40).

The potential gain is about 19% of the amount of capital risked. This trade will be open 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, VIRT 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 stock trading tips Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.