Learning from Stocks that Go Against the Trend
Source: National Beverage.com
On Friday, the unemployment report boosted the stock market. Major indexes rallied sharply, and traders were generally bullish. On a day like that, we can learn a lot by looking for stocks that moved down instead of up.
Stocks that don’t participate in the broad market trend, especially when the trend is up, could be the best stocks to trade. The reason for this is that the stock moving against the market trend is moving based on its fundamentals and its fundamentals are either much stronger or weaker than average.
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On a strong up day, the stocks that lose the most are sending a signal to traders. Analysts at major Wall Street firms will need to study the company’s financials to decipher what that signal is. They need to explain the stock’s movements to their clients.
Traders, on the other hand, may not need to understand the underlying factors. It could be enough to understand that the fundamentals are perceived to be weak in the short term. With that insight, a trading strategy can be developed to benefit in the short term.
National Beverage Fizzles
National Beverage Corp. (Nasdaq: FIZZ) reported earnings per share (EPS) of $0.88, better than analysts’ expectations for $0.68. Revenue of $227.5 million for the quarter, however, was well below expectations for sales of $232.1 million.
Traders were disappointed in the slowdown in sales and they responded by selling. The magnitude of the selling can be seen in the chart below which also includes the MACD, a momentum indicator that has generally been bearish for some time.
The selling comes after a period of prolonged weakness in the stock that is shown in the next chart. This chart provides a longer term view of the price action using weekly data.
MACD, as well as other momentum indicators that are not shown, have been bearish since the stock traded at an all time high late last year. Momentum indicators, especially when they are in agreement in two or more time frames, can be powerful tools, but they should be confirmed with other indicators.
In this case, the chart pattern confirms the bearish outlook. This is a topping pattern and the down move broke important support levels. In addition, the news, a shortfall in revenue relative to expectations, is also bearish.
Weak momentum, and a large move against the trend on a strong day for the market, indicate the most likely direction of the short term trend in National Beverage is down.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a short term rebound in FIZZ seem to be remote. Traders should consider using an options strategy known as a bear put spread to benefit from the expected downward price move.
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.
The Trade Specifics for FIZZ
The bearish outlook for FIZZ, 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 April 20 $80 put can be bought for about $2.00 and the April 20 $75 put can be sold for about $1.00. This trade will cost about $1.00 to enter, or $100 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 $100. This loss would be experienced if FIZZ is above $80 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 FIZZ, the maximum gain is $4.00 ($80 – $75 = $5.00; $5.00 – $1.00 = $4.00). This represents $100 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $100 to open this trade.
That is a potential gain of about 300% of the amount risked in the trade. This trade delivers the maximum gain if FIZZ closes below $75 on April 20 when the options expire. There is a relatively low probability of that according to the options pricing models. That indicates the gain is likely to be less than the maximum possible gain.
Put 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 $100 for this trade in FIZZ.