Look Beyond the Obvious Suspects If the Economy Weakens
Investors are becoming concerned. And, they should be. There are a number of signs that the economy is weakening. So it is important for investors to look at how that expected weakness could affect the stock market.
In broad terms, the slowdown could push broad stock market averages lower. That’s important because many investors will see their account values fall when that happens. Knowing that, some investors will still panic and make important mistakes when the decline accelerates.
There were reports in 2008 of investors selling all of their stocks as prices fell. There were also reports of investors failing to get back into stocks after the stock market bottomed in March 2009. Failing to get back in would certainly be a normal and expected reaction.
After stocks bottom, investors will look for indicators to confirm that the down trend is over. Unfortunately, there are unlikely to be significant signals that the danger is behind us. In fact, the news is likely to be bad. Yet, stocks will be rising.
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That is likely to be the mirror image of the top of the stock market. At tops, we tend to see good news and after delivering good news, we see companies fall. That was the case with Elastic N.V. (NYSE: ESTC) recently.
Good Earnings Fail to Boost the Stock
ESTC recently announced results for the most recent quarter. Business Wire reported, that total revenue was $63.6 million, growing 72% year-over-year. The company reported a loss but the stock market has been focused on sales.
Even knowing the company was far from profitable, ESTC had been able to raise $264 million in a public offering and the stock had done well.
The company’s CEO noted the strength of the performance“We are very pleased with our Q2 results; our team delivered strong revenue growth of 72% year-over-year,” said Shay Banon, founder and chief executive officer at Elastic.
“Search is an incredible foundation to enable our users and customers to address a variety of use cases. We’re proud of the pace of innovation across our self-managed and SaaS offerings and the rapid adoption of the Elastic Stack and our solutions by our users and customers.”
But the news sparked a sell off in the stock.
It is possible that ESTC will recover. But if the economy is slowing that is unlikely. Traders tend to look for less aggressive companies in an economic down turn and favor companies with strong earnings and earnings growth. This could mean that ESTC is headed significantly lower.
However, the stock remains risky and it could be best to implement strategies that limit risk while seeking to benefit from the down side potential 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 ESTC
For ESTC, we could sell a December 21 $75 call for about $3.95 and buy a December 21 $80 call for about $2.20. 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 short term holding period. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if ESTC is below $75 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 ESTC.