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Digging Deep to Find Trades

Digging Deep to Find Trades

Traders have developed a variety of techniques to identify potential buys and sales. Some will use a value methodology. Others prefer a technical or quantitative strategy. Some rely on the news. This is part of the strategy many hedge funds use.

There are some events managers will know are scheduled. This could be an election like the US Presidential election last November. Some fund managers believed a Trump victory would have a negative impact on the Mexican economy. Their outlook can be seen in the chart below.

This is a weekly chart of the US Dollar (USD) and Mexican Peso (MXN) currency pair. A move up on the chart means the peso is weakening relative to the dollar since it shows more pesos are required to buy one dollar.

The trend for the peso weakened throughout 2015. Speculation about the election began to grow in the summer of 2016 and the peso weakened further. But, few analysts expected Donald Trump to win the election in November. When he did, the peso moved sharply as the chart shows.

Over time, traders realized that policy action was unlikely to match the level of campaign rhetoric. This meant fund managers took profits and the peso began to show strength after the inauguration in January. Now, the peso is back to its pre-election level and most likely trading in line with economic data.

Sometimes the News Hides a Trading Opportunity

More recently in the news, there was that tragic fire in London. The fact that there is a trading opportunity associated with that event is not meant to diminish the scope of the tragedy. The fact is that whenever a tragedy occurs, the companies involved should be closely evaluated. Liability associated with the events can bankrupt a company.

An example of that is in this week’s news. Japan’s Takata collapsed under the costs associated with its exploding airbag crisis. The company’s faulty airbag inflators were shown to be capable of blasting shrapnel into drivers and passengers.

This problem led to the recall of tens of millions of vehicles and was linked to 11 deaths in the US and more in other countries. As debts topped $9 billion, Takata was forced into bankruptcy protection in Japan and the US.

Takata’s story is a reminder that companies don’t always survive tragedy. That could be true for Arconic Inc (NYSE: ARNC), a company now associated with the Grenfell Tower fire that occurred on June 14. Grenfell Tower was a 24-story, 220-foot tall block of public housing apartments in North Kensington, west London. The fire killed at least 79 residents and injured dozens more.

The fire spread rapidly, at least in part, because of a cladding that had been installed largely for decorative purposes. Subsequent investigations have shown that every single high rise building in London the government tested for combustible siding has failed the safety test.

According to reporting on the tests, “News of the widespread failures has angered the public, and it prompted Arconic, the US company that supplied the siding, to announce it will no longer sell it.” This comes at a time when shares of Arconic are already in a downtrend.

Negative news is likely to lead to a continuation of the downtrend which has been in place since 2014.

Arconic Inc. was formerly known as Alcoa. The company produces aluminum sheet and plate products for the aerospace, automotive, commercial transportation, brazing and industrial markets. Other markets include products made of titanium and nickel.

This siding product is a small part of its business but is likely to be a significant weight on the company for some time. The tragedy at Grenfell Tower seems to have been easily preventable.

The siding, called Reynobond PE, had an aluminum exterior but was plastic on the inside. The plastic can act as a fire accelerant. In the US, Reynobond PE is only approved for use in shorter buildings because of fire safety concerns. But, Arconic has sold the product in other markets around the world.

In a statement Monday, Arconic said: “Because of the inconsistency of building codes across the world and issues that have arisen in the wake of the Grenfell Tower tragedy regarding code compliance of cladding systems, Arconic is discontinuing global sales of Reynobond PE for use in high-rise applications.”

Perhaps most tragic of all, Arconic makes a similar siding with a flame-resistant core. But at Grenfell Tower the contractor chose to use the cheaper version in an effort to save about $2.50 per square meter.

Now, Arconic May Struggle to Survive

The fact that the company limited sales in the US indicates management was aware of the risks. This could become a problem for the company as investigations continue. It could pose a significant problem if litigation develops.

As the chart above shows, Arconic has already been in a downtrend. This reflects the company’s deteriorating fundamentals. Earnings per share (EPS), before various accounting changes, have been negative in each of the past four full years.

Analysts have been expecting a turnaround in the company. EPS for this year are expected to be $1.17 based on estimates from nine analysts covering the company. There are also nine estimates for next year when EPS are expected to grow to $1.51. For 2019, seven analysts have published forecasts indicating EPS should continue rising to $1.86.

None of these estimates include potential charges related to the Grenfell Tower tragedy. It is likely estimates will be revised downward to account for potential liabilities associated with that event.

This makes ARNC an excellent short trade candidate. But, the potential costs and risks of shorting a stock are high. In order to open a short position, traders need to borrow shares from their broker. They will be required to pay interest on this loan until the close they trade. The cost of borrowing can change suddenly and can be expensive.

Rather than directly shorting a stock, many traders use options strategies to create a position that can benefit from a decline while limiting risk. One way to do that is with a long put.

Trade Specifics

A long put is among the simplest options strategies. It involves buying just one contract, a put option that benefits from a price decline. Risk is limited to the amount paid to purchase the put option. This strategy offers full participation in the downside of the stock once the stock is below the option’s exercise price.

The risk reward profile for this strategy is shown below.

For Arconic, the downside is likely to last for several months. This means an option with at least several months to expiration is suitable for the trade.

The stock closed on Tuesday at $21.84. There are options available with expiration dates as far out as January 2019. Options with this much time to expiration generally trade at high prices. An at the money January 2019 put with an exercise price of $22.50 is trading at about $4.25.

Options expiring in October are also available. The $23 put option expiring at the close on October 20 is trading at $2.10. This option fully participates in the downside if ARNC falls below $20.90, an amount equal to the option exercise price less the premium paid.

Buying the October $23 put for $2.10 offers significant potential for gains and carries limited risk. If Arconic is still trending lower in October, a new put can be purchased to continue participating in the downtrend. But, with limited risk, long put strategies could be the best trade available in ARNC.