Here’s Why Catching a Falling Knife Can Be a Bad Idea
Source: Campbell Soup Company
It’s a cliché among traders. They spot a blue chip company in a down trend and two distinct trains of thought emerge.
One group sees a potential bargain. After all, they argue, this is a big name and they can’t possibly go out of business. The problems are temporary and it could deliver a large gain when the turn around comes. Since the turn around is inevitable in a big company, they believe, the stock is a buy.
Another group sees a falling knife. Just like in the kitchen, a knife can fall towards the floor and a decision needs to be made. You could reach out and try to catch it or get out of the way and allow the knife to fall to the floor.
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Sometimes, individuals try to catch the falling knife in the kitchen. There is exactly one right way to do that – grab the handle. There are countless wrong ways to grab the knife – grabbing the blade or part blade and part handle or any combination thereof.
Risks are high when you decide to catch a falling knife in the kitchen. The same is true in the stock market.
Another Falling Knife Cuts Investors
Campbell Soup (NYSE: CPB) provides an example of the falling knife in action. It’s a blue chip company that has products in almost all American households. So, a decline in price could be perceived as a buying opportunity.
The chart below shows CPB at the beginning of 2018. A perfect falling knife set up.
Investors who tried to catch the knife learned more about the company’s fundamentals in its latest earnings release.
Campbell Soup had a third-quarter net loss of $393 million, or $1.31 per share, after income of $176 million, or $0.58 per share, during the same period last year. Adjusted EPS was $0.70 cents. Revenue totaled $2.13 billion, up from $1.85 billion, year-over-year.
The FactSet consensus was for EPS of $0.60 cents and sales of $2.13 billion. The company is addressing its challenges, both external and “execution-related,” with “renewed urgency,” said Chief Financial Officer Anthony DiSilvestro in a statement.
While earnings were close to expectations, the company also cut its earnings guidance, and now expects 2018 adjusted EPS to fall 5% to 6% to $2.85 to $2.90, pushed down by the Snyder’s Lance acquisition.
The previous guidance was for an adjusted EPS decline of 1% to 3%. The FactSet consensus is for EPS of $3.11. Sales are expected to grow 10% to 11%, up from previous guidance for flat to growth of 1%, also due to the acquisition.
But, the company had more news to deliver. The announcement said Chief Executive Officer Denise Morrison is retiring and will be replaced on an interim basis by board member Keith McLoughlin.
Morrison, 64, who has been at the helm since 2011, is stepping down, immediately, Campbell said in a statement. She has been with the company for 15 years. McLoughlin, 61, has been a board member since 2016.
Campbell has been seeking other sources of growth as it grapples with a soup slowdown.
In December, the company agreed to buy Snyder’s-Lance in a bid to push deeper into salty snacks — a bright spot in the struggling packaged-food industry. That deal gives Campbell, which makes Goldfish crackers, brands such as Cape Cod potato chips and Snyder’s pretzels. But, the benefits seem to be delayed.
The stock’s reaction to the news shows the danger of the falling knife.
It seems unlikely that CPB will make a strong recovery from the recent sell off.
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 CPB
For CPB, 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 a June 15 $35 call for about $1.00 and buy a June 15 $37 call for about $0.30. This trade generates a credit of $0.70, 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 $70. The credit received when the trade is opened, $0.70 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $130. The risk is found by subtracting the difference in the strike prices ($200 or $2.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($70).
This trade offers a potential return of about 53% of the amount risked for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if CPB is below $35 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 $130 for this trade in CPB.
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