Expansion Plans of This Company Could Signal a Top
Markets all move between periods of rising prices and falling prices. There are times when investors seem to believe otherwise, but when that happens a trend reversal often occurs to remind investors that prices move both up and down.
One example of a market where investors seemed to forget about the possibility of declines was the housing market in the early years of this century. There were many sales pitches from real estate agents and mortgage brokers that everyone should buy because prices only go up.
Well, the housing crash shattered that illusion.
Source: Federal Reserve
Companies Can Forget About Risks as Well
But, it’s not just individuals who can forget about the risks in a market after an extended price rise. Large companies, even those with expertise in the industry, can seemingly forget about the risks as well. That could be the case with Zillow Group (Nasdaq: ZG).
Zillow is a popular web site that provides information about home prices. Several months ago, the company announced it was looking to potentially flip homes in the Phoenix and Las Vegas areas.
At the time, the company explained that “when Zillow buys a home, it will make necessary repairs and updates and list the home as quickly as possible.”
“A local agent will represent Zillow in the purchase and sale of each home, enabling agents to earn commissions,” the company added. The plan was to buy a home, make needed repairs and sell it within 90 days.
Analysts questioned the move and several expressed skepticism.
Ronald Josey of JMP Securities wondered why Zillow was deciding to become a real estate investor. “Most of Zillow’s mission is about being in a marketplace with advertising-based tools and to help referrals for agents,” he said. “But now with taking on inventory, it’s a little bit of a different picture,” he said.
Lloyd Walmsley of Deutsche Bank was even more blunt. “Why now?” he asked. “This seems like an awfully big pivot in terms of business model, taking a lot of inventory risk and using a lot of capital.”
Zillow CEO Spencer Rascoff argued, “I can say without exaggeration that no company understands the American home buyer and home seller better than Zillow Group. And after extensive study, we believe that this is a big opportunity. So that’s why now.”
Traders agreed with the analysts at first and the announcement can be seen in the chart below where a gap down marks the news from April.
Another Down Move Unfolds
The stock suffered another decline last week after Steven Eisman, managing director at Neuberger Berman, was interviewed on Bloomberg about his short trade on the company.
Eisman said its growth has slowed dramatically and that its decision to start flipping homes means it’s entering a “terrible business” that’s cyclical in nature and generates low margins.
The company is set to release earnings in August and the stock has historically fallen, on average, after earnings announcement. That sets up a potential trading opportunity for short term traders.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a further short term gains in ZG seem to be remote. But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for ZG
The bearish outlook for ZG, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the August 17 $55 put can be bought for about $1.60 and the August 17 $50 put can be sold for about $0.80. This trade will cost about $0.80 to enter, or $80 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $80. This loss would be experienced if ZG is above $55 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in ZG, the maximum gain is $4.20 ($55 – $50 = $5; $5 – $0.80 = $4.20). This represents $420 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $80 to open this trade.
That is a potential gain of more than 425% of the amount risked in the trade. This trade delivers the maximum gain if ZG closes below $50 on August 17 when the options expire.
Put 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 $80 for this trade in ZG.