Don’t Bet Against the Market
Academic theories argue that the market knows best. Some forms of the Efficient Market Hypothesis, in particular, hold that the current market price of a stock reflects all of the information that is available about the company. This is a logical conclusion.
Traders make decisions about stocks all the time, and, of course, a decision not to make a trade is actually the expression of a bullish or bearish opinion. So, in the market at any given moment, we have investors buying, selling, holding and avoiding a particular stock.
Cumulatively, the actions of all of these investors sets the market price of the stock. While we may not know what any individual investor believes about a stock, we know that the general trend in the price of the stock demonstrates the opinion of the majority of investors.
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In this case, the market price is not reflecting the results of a survey of all investors. It is showing the intensity of the buying or selling power of groups of investors. It doesn’t matter if 99% of all investors are bullish if none of them are buyers. In that case, the seller determines the trend.
Multiple Market Trends Can Confirm Each Other
At times, investors will have an opportunity to express their opinion in multiple markets. This is true for a number of large stocks, including the drug company Bristol-Myers Squibb Company (NYSE: BMY).
In the stock market, traders are demonstrating through the trend that they are bearish. This can be seen on the chart below.
This view seems to be confirmed by derivatives traders. Although many traders ignore the indicators provided by the derivatives market, they can be important since they tend to lead the trend in the stocks.
Credit Default Swap (CDS) spreads provide insight into investors’ perception of the credit quality of a company. IHS Markit’s CDS index track this indicator. The index compares the current 5-year CDS spread to its most recent one and three year ranges to measure relative credit sentiment.
Increases in CDS spreads often indicate credit concerns for a bond issuer. BMY’s spread is shown below.
Source: IHS Markit
BMY credit default swap spreads are rising, indicating some deterioration in the market’s perception of the company’s credit worthiness. Now, the spread is at a three year high, a condition that indicates traders are bearish on the company.
In the short run, there is unlikely to be a significant rally in BMY. It will take time for traders to gain confidence that the company is recovering from its problems. That creates a trading 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, a call option should be sold.
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 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 BMY
For BMY, we have a number of options available. Short term options allow us to trade frequently and potentially expand 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 April 20 $60 call for about $0.60 and buy an April 20 $62.50 call for about $0.15. This trade generates a credit of $0.45, 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 $45. The credit received when the trade is opened, $0.45 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $205. The risk is 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 ($45).
This trade offers a potential return of about 22% of the amount risked for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if BMY is below $60 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 $205 for this trade in BMY.
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.