How to Trade High Priced Stocks
In the current market, some stocks are trading at high prices. Many individual investors have been unable to participate in trades in these stocks because the stock is priced at more than $300 a share. However, there are some strategies that can make these stocks accessible.
Importantly, there are strategies that can help small investors benefit from both bullish and bearish news. An example is some recent bearish news in a stock priced near $300 a share. According to Benzinga,
“DNA sequencing and array-based technologies company Illumina, Inc. (NASDAQ: ILMN) pre-announced second-quarter results that represent a “big miss” versus expectations, according to Bank of America Merrill Lynch.
The news pushed the price down.
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The company recent announced that it expects second-quarter revenue to be roughly flat year-over-year at $835 million, which is short of the $890 million expected. In addition to warning for this quarter, Illumina also lowered its full-year sales growth expectations from 13%-14% to 6%.
[On the news] Derik de Bruin downgraded Illumina from Buy to Underperform with a price target lowered from $355 to $290.
In a note to investors, de Bruin noted that there are several areas of concern including delayed sales, weakness in the direct to consumer market and competition from lower priced systems.
He noted that “the revision is “particularly surprising” after management offered positive commentary over recent months, de Bruin said.
Despite a double downgrade to a bearish stance, the analyst said he remains “emphatically bullish” on the long-term potential and opportunity in the sequencing market.
The ongoing drop in the cost of sequencing has resulted in the company expanding the number of applications, and multiple new markets such as liquid biopsy and population genomics remain in the very early stages, he said.
Investors should view his bearish stance as merely a function of near-term uncertainty and not a reflection of long-term fundamentals, de Bruin said.”
The stock fell from 52-week highs on the news and that could be bearish in the short run.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a further short-term gains in ILMN 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.
Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
The Trade Specifics for ILMN
The bearish outlook for ILMN, 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 September 20 $300 put can be bought for about $13 and the September 20 $290 put can be sold for about $9.90. This trade will cost about $3.10 to enter, or $310 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 $310. This loss would be experienced if ILMN is above $300 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 ILMN, the maximum gain is $6.90 ($300 – $290 = $10; $10 – $3.10 = $6.90). This represents $690 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $310 to open this trade.
That is a potential gain of about 122% of the amount risked in the trade. This trade delivers the maximum gain if ILMN closes below $290 on September 20 when the options expire.