New Year’s Resolutions Can Be Profitable
It’s a new year. Many of us woke up a little early and squeezed some exercise into our day. Regular gym goers know there are a few extra people around this week. But, regular gym goers also know the crowd won’t last. That can be seen in the data in the chart below.
Source: Google Trends
That’s a chart of Google queries for “gym membership.” The chart shows a spike every January. This can be assumed to represent New Year’s resolutions. And, as the chart shows the interest quickly fades. But, there is even more interest in dieting as the calendar shows the start of a New Year.
Source: Google Trends
Spikes in searches for “diet” are even more pronounced than searches for gym membership. Here, the trend is even clearer. Notice that the pattern repeats year after year with a spike in January and then months of decline which represents waning interest.
From Google Trends to Business Trends
The charts above were generated with Google Trends and charts the level of interest in various search terms. As the charts show, patterns do appear in some types of searches. For example, these terms show that resolutions fade quickly with the seasons.
Seasonal patterns exist in other data besides Google searches. This would be expected since Google simply reflects other patterns of behavior. One area where seasonal patterns exist is in stock market data.
Companies often experience seasonal trends in their business. This is obvious when we think about it. Retailers, for example, should be expected to see a surge in business at certain times of the year. Holiday shopping is one of those times when a surge is expected. Back to school shopping is another.
Retailers know this time of year will be busy for them and that means they will want to be prepared. They will stock up on inventory in the weeks before shoppers are expected to fill the aisles. This means manufacturers will be busy in the months before shoppers look for the hottest item in stores.
These obvious seasonal trends, holiday shopping and back to school shopping, create bumps in the business activity of retailers, their suppliers, the companies that make raw materials for their suppliers, transportation companies and others.
The bumps in activity are predictable. Retailers will stock up weeks before the shopping season. Manufacturers will work extra to deliver goods on schedule. Their suppliers will be busy before manufacturing revs up. Transportation companies will move goods to meet these requirements.
This predictability leads to certain patterns in stock prices. Seasonal trends exist in stocks and can be traded. However, seasonals will always carry a degree of risk because other factors can overwhelm and counteract the seasonal trends. However, seasonals can be the basis of trades when risk is managed.
A Trading Opportunity to Benefit From Failed Resolutions
The chart below shows a seasonal trend in the price of one company.
This company benefits from the annual resolution to lose weight and the stock price has gone up in December 75% of the time since the company began trading in 2001. But, dieters quickly lose their resolve and the stock falls 56% of the time in January.
Seasonal trends are found by averaging the price action over time. For example, we can find the average percent change in price every day of the year for a stock and then average all those changes to create an indicator like the blue one shown above.
As you may realize, the chart of Weight Watchers International (NYSE: WTW) is shown above. The diet company, not surprisingly shows a strong seasonal trend as traders buy in anticipation of new customers and sell when they realize many new customers will abandon their plans quickly.
The expected short term down trend in the stock creates a trading opportunity.
To benefit from weakness, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook, a call option should be sold.
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 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 exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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 WTW
For WTW, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell a February 2 $50 call for about $2.00 and buy a February 2 $52.50 call for about $1.00. This trade generates a credit of $1.00, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $100. The credit received when the trade is opened, $100 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $150. The risk is found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($100).
This trade offers a return of about 67% for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if WTW is below $50 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 $150 for this trade in WTW.
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.