How Small Traders Can Trade Even When Stocks Really Are More Expensive
Investors may feel like stocks are more expensive than ever. This applies to valuation metrics, such as the price to earnings (P/E) ratio and other popular tools. It also seems to apply to the dollar cost of a single share.
Anecdotally, this seems to be accurate. Stocks, in the old days, seemed to split when they reached higher prices. For example, trading books from decades ago describe strategies that involve buying stocks nearing $100 a share in anticipation of a split.
A stock split can be declared by a company at any time. For example, a company might have 100 million shares outstanding. They could decide to split the shares 2 for 1, or 2:1 in the format companies use. Other ratios, such as 3:1 or 7:1 are possible. So are reverse splits which could be in the ratio of 1:5, for example.
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The split immediately reduces the price of the stock. For example, if a stock is priced at $100 and an investor owns 100 shares before a split, the investor now owns 200 shares priced at $50. The financials are also changed so P/E ratios and other metrics remain the same.
Now, stock splits seem to be announced less frequently. This highlights the fact that a split had no impact on a company’s finances. Companies have no incentive to announce a split. But, that means stock prices can be higher than they were in the past.
The Impact on Small Investors
Higher prices might not matter to the companies, but they can make a difference to small investors. High prices can make it difficult for small investors to buy a sufficient number of shares to obtain a meaningful position in a stock and to build a diversified portfolio.
But, there are options strategies that can be used to obtain exposure to high priced stocks. These strategies require small amounts of capital and can allow for diversification. These strategies are also short term which means they can allow for frequent turnover of capital.
Some strategies will require a directional opinion on the stock. One way to take a lower risk directional opinion is to wait for news and to expect follow through in the direction of the market’s initial reaction. For example, a jump on earnings could indicate a bullish opinion is warranted.
W.W. Grainger Inc. (NYSE: GWW) offers an example. The stock is priced at more than $300 a share and the company recently announced earnings which led to a rally.
The supplier of maintenance and repair products reported earnings per share of $4.16 and revenue of $2.86 billion. The FactSet consensus was for EPS of $3.70 and sales of $2.82 billion.
“The second quarter exceeded our expectations, with strong growth from U.S. large and medium customers, gross profit that was better than anticipated and meaningful operating expense leverage,” Chief Executive DG Macpherson said in a statement.
The company also raised its guidance for the full year and said it now expects sales of $11.0 billion to $11.3 billion, up from previous guidance of $10.9 billion to $11.3 billion. Adjusted EPS is now forecast at $15.05 to $16.05, up from $14.30 to $15.30 previously.
The annual guidance is also above expectations. The FactSet consensus is for full-year EPS of $14.99 and sales of $11.2 billion. This bodes well for the stock, which is in a long term up trend.
The trend is now likely to continue. However, at more than $300 a share, trading the stock is out of reach of many small investors.
Trading the Trend
When a stock is expected to move higher or pull back slightly, traders could consider obtaining long exposure to the stock to profit. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which is in an up trend.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
A Specific Trade for GWW
For GWW, a bull put spread could be opened with the August 17 put options. This trade can be opened by selling the August 17 $310 put option for about $2.00 and buying the August 17 $300 put for about $0.80.
This trade would result in a credit of $1.20, or $120 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $10 ($310 – $300). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $880 ($1,000 – $120).
The potential gain is about 13.6% of the amount of capital risked. This trade will be open for about one month and the annualized rate of return provides a significant gain.
The bull put spread is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy also has a high probability of success.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.