How to Trade Stocks With Triple Digit Prices
Investors in Chipotle Mexican Grill Inc. (NYSE: CMG) have enjoyed large gains and large declines. The stock was among the biggest winners in the early stages of the bull market that began in 2009. In the next seven years, CMG gained nearly 2,000%. But, since then, the stock has struggled.
Chipotle’s problems are well known. In fact, the company will offer business school students a case study in problems associated with growth for years to come.
Years of Problems
The biggest problems the company faced unfolded in 2015. An E. coli outbreak resulted in the company being listed as one of the 17 worst cases of foodborne illnesses in US history.
Between October and November 2015, about 55 people in 11 states became ill after eating at the restaurant during the initial outbreak. There were 22 reported hospitalizations and no deaths. In a second outbreak for this fast-food chain, five people became ill from a different strain of E. coli.
Earlier that year, Chipotle restaurants were tied to a norovirus outbreak in California and a salmonella outbreak in Minnesota.
The problems resulted in the company’s first-ever quarterly sales slowdown as a public company in its fourth-quarter 2015 earnings report. To restore confidence in its menu, Chipotle made a number of changes in how it handled food and training. This addressed concerns that rapid growth had led to compromised safety processes.
In 2017, the stock formed a bottom and moved up by more than 20%. But, the rally seems to have run out of steam.
This week, shares fell sharply after management noted in a Securities and Exchange Commission filing that food costs are rising and the company intends to dramatically increase marketing expenses to restore consumer confidence.
The result will be seen in the company’s bottom line as higher operating costs result in lower profit margins and lower earnings per share.
Chipotle now faces uncertain prospects. The truth is many potential customers remember the problems of a few years ago. Those customers are concerned that they could get sick eating at Chipotle. And, they have plenty of alternatives. A number of alternatives even offer lower prices than the relatively expensive menu at Chipotle.
Chipotle also faces angry workers. Earlier this month, lawyers filed a proposed class-action lawsuit against Chipotle alleging the company should be paying time and a half to employees who work more than 40 hours a week and earn less than $47,476 a year.
The lawsuit will take time to play out but is another problem for a company besieged on several fronts.
The Stock Shows the Company’s Stress
At least some investors are joining consumers in questioning Chipotle’s value. Value investors can point to valuation ratios that are stretched for a company facing so many potential problems.
Analysts tend to be overly optimistic about the future but we can assume their earnings estimates are accurate to value the stock. They expect Chipotle to report EPS of $8.47 this year and $12.26 next year. Based on next year’s expected earnings, the stock is trading with a price to earnings (P/E) ratio of 34.
Restaurant stocks have been expensive throughout this bull market. The long term industry average P/E ratio has been 22, well above the market average. Chipotle is trading at a 50% premium to its peers.
The price to book (P/B) ratio and price to sales (P/S) ratio confirm the overvaluation. Chipotle trades with a P/B ratio of 9.4, more than 3 times the industry average of 2.8. The P/S ratio of 3.2 for Chipotle is 2.6 times the industry average ratio of 1.2.
These valuations indicate the company needs to deliver strong earnings and the facts indicate that will be difficult to do. The downside risks in CMG appear to outweigh the potential upside in the stock.
The stock chart confirms a large amount of risk in the stock.
In the chart above, the stochastics indicator is shown in the middle of the chart and the MACD indicator is at the bottom. Both of these indicators measure momentum. Technical analysts believe momentum leads price and down trends in momentum are usually followed by declines in price.
The stochastics indicator has been moving lower for the past few weeks. The MACD indicator turned negative this week, confirming the trend in momentum is lower.
One Problem Is the Stock Price
While fundamental ratios and technical indicators tell us the outlook for CMG is bearish, many individual investors lack the ability to trade the stock with standard tools. CMG is trading at $417.71, a price that makes even 10 shares expensive for many investors.
To benefit from a stock’s decline, traders can sell the stock short. This involves selling the stock and borrowing shares from your broker. Eventually, you buy the stock back in the open market and repay the borrowed shares. If prices fall while you are short, the trade generates a profit.
But, the risk of a short trade is unlimited in theory and large in practice. If Chipotle rises, you face a loss on the trade and could owe your broker hundreds of dollars in charges for the loan.
Put options also benefit from a price decline. In this case, you could buy a put on CMG expiring on July 21 with an exercise price of $415 for about $11. Each contract covers 100 shares so the cost to enter that trade is $1,100.
The breakeven level on that option is $404, meaning CMG must decline by more than 2% before you enjoy any profit potential on the trade.
This is a reality of options trading – options on stocks with high prices will trade at high prices. This means buying many options will still be out of the reach of many small investors.
A Solution Is Available to That Problem
A spread options strategy can overcome that problem. It may even be possible to get paid to trade in these stocks.
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 strike price of the call you sell will be below the strike of the long call, so this strategy will always generate a credit when it is opened.
The risk profile of this trade from The Options Industry Council web site is shown below.
The trade has limited up side and limited risk. But, it allows traders to generate potential gains in a stock they could not otherwise trade.
The potential gain in the trade 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 CMG
For CMG, we could sell a July 21 $450 call for $2.75 and buy a July 21 $462.50 call for $1.40. This trade generates a credit of $135 and risks $1,115. This is about the same amount of risk we would accept for buying the put option.
This trade offers a return of about 12% for one month. This is a significant return on the amount of money at risk but there are trades available for less risk.
We could also buy the July 21 $460 for about $1.63 when selling the $450 call. This trade generates a credit of $112 and the risk is $888, a potential 12.6% return on risk.
Other variations are also possible. It is possible to find trades requiring less than $250 in risk capital. The bear call spread could be used to generate steady income in stocks that are too expensive to trade otherwise.