Higher Interest Rates Could Doom This Software Company
Interest rates are rising and that has consequences for a number of markets. Auto makers, for example, could see a decline in demand as higher interest rates increase the required monthly car payment. Appliance makers face a similar problem and so do home sellers.
Home prices have an impact far beyond the individual homes that are bought and sold. Many agents and lenders are involved in the sales process. Many retailers, like furniture stores, and service providers, like carpet cleaners, are affected by home sales. Increasingly, tech companies are also affected.
Zillow Could Be a Casualty of Soft Housing Markets
CNBC reported that “home sales platform Zillow shed more than a quarter of its market value in one day as a downturn in the housing market weighs on the company’s core services and drags profits lower.
The 26-percent plunge sent Zillow to a new 52-week low and made for the stock’s worst day of trading since going public in 2011.”
Earnings were the catalyst for the price move.
“Zillow missed Wall Street estimates for third-quarter revenue, posting $343 million compared with the $344 million analysts had predicted. It also guided toward lighter fourth-quarter results, expecting revenue between $340 million and $357 million, well below the $368 million Wall Street had been expecting.
[The company also] lowered its full-year revenue guidance for the second quarter in a row, to a new range of $1.31 billion to $1.32 billion, from a previously adjusted range of $1.32 billion to $1.35 billion.”
Core business stumbles.
Earlier this year, Zillow launched a new strategy of buying and selling homes directly to users, expanding its offerings beyond real estate brokers. The company in August bought a mortgage lender to assist with sales.
The new business segment appears to be taking off, posting quarterly revenue of $11 billion, compared with company expectations of between $2 billion and $7 billion.
But the company’s core agent-backed services rang in below revenue estimates amid rising interest rates, a stalling housing market and tweaks to the company’s Premier Agent business that pairs brokers with real estate leads.
“The negative feedback received over the past several months has been far greater than the company had anticipated. Management found many Premier Agents were displeased with the lower lead volume, despite leads being higher quality,” analysts for Stifel wrote in a note.
Zillow plans to adjust the new system, but risks to the broader housing market could still weigh on transaction leads.
Last week, total mortgage applications dropped to a 4-year low, according to the Mortgage Bankers Association’s seasonally adjusted index, as the average contract interest rate hit an 8-year high.
“People aren’t shopping for homes because they become less affordable as rates rise,” trader Jon Najarian, of the Najarian Family Office, told CNBC on Wednesday.
“What [the Federal Reserve and Chairman Jerome Powell] meant to do, slowing down the growth of the economy, they have accomplished. And now if they keep basically putting their foot on the brake, they’re going to hurt it.”
This could accelerate the down trend in the stock.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
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 traders can consider is the bear call spread. This is a trade that 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. The call is sold to limit the risk of the trade. So this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It 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 and is also known.
A Bear Call Spread in Z
For Z, we could sell a December 21 $30 call for about $2.47 and buy a December 21 $35 call for about $0.72. This trade generates a credit of $1.75, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $175. The credit received when the trade is opened, $175 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $325. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($175).
This trade offers a potential return of about 54% of the amount risked for a holding period that is about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if Z is below $30 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 $325 for this trade in Z.
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.