News Can Hurt Overvalued Stocks the Most
Some news stories just bounce away from the headlines and never seem to influence the price of a stock. Other news stories can deliver a devastating blow to shareholders, destroying billions of dollars’ worth of wealth in hours, or even at times, in minutes.
News that broke about Wynn resorts, Limited (Nasdaq: WYNN) illustrated this point. The news was widely covered and the stock’s decline was rapid.
Moves on News Can Be Both Quick and Sustained
The Wall Street Journal headline provided enough details that no one needed to read the story. “Dozens of People Recount Pattern of Sexual Misconduct by Las Vegas Mogul Steve Wynn.”
The one minute chart shown below shows that many traders sold as they read the headline.
That large decline as the story came out could be the work of high frequency trading firms using natural language processing software to scan news stories. It seems as if human traders might have needed another few minutes to grasp the significance.
As is often the case, the sub headline added details in case traders wanted to know more before acting, “Wynn Resorts employees and others described a CEO who sexualized his workplace and pressured workers to perform sex acts. Mr. Wynn responded: ‘The idea that I ever assaulted any woman is preposterous.’
There it was, enough information to make a decision. If traders really wanted to know more, the article offered the salacious details. But, the fact that the article appeared in The Wall Street Journal told traders a great deal. This was a reputable source and lawyers had undoubtedly vetted the news.
The five-minute chart shows that many traders did grasp the significance of the story. The large bar in the upper left shows the immediate reaction. Selling pressure remained in place throughout that day and accelerated after the weekend.
China Adds to the News Driven Sell Off
Monday’s selling came after the government of the Chinese territory, Macau, announced that officials have talked with Wynn management and want to make sure major shareholders, directors and key employees meet suitable qualifications, the Gaming Inspection & Coordination Bureau said in an email.
The Bloomberg article on this development noted that, “The Asian gaming enclave now accounts for more than three-quarters of Wynn’s earnings, and the casino operator has big plans for a further expansion after opening the Wynn Palace there in August 2019.”
However, there were signs that the development would not have a long term impact on operations.
Macau legislator Jose Coutinho said Wynn’s situation shouldn’t create difficulty with its operating license, as the personal allegations don’t hurt the enclave’s image as much as more damaging industry scandals in the past that didn’t spur changes in the laws.
“The former Portuguese colony is not responsive enough to solve problems that have caused negative impact to the society,” he said.
But, Valuation May Hold the Key to the Decline
The news came as the stock was trading with a price to earnings (P/E) ratio above 50.
Source: Standard & Poor’s
Historically, WYNN has traded with an average P/E ratio of 34 over the past five years. However, earnings growth was expected to average about 8% in the next five years, in line with the average growth of large companies but not fast enough to support a higher than average valuation.
That overvaluation could have been the trigger for traders to take profits. The news is likely to weigh on the company in the short run as the board of directors stops focusing on other issues to address these allegations.
Meanwhile, lawyers are circling the company and a number of lawsuits should be expected to be filed in the relatively near future. These filings will lead to further distractions for management and the board even though they are needed to address the alleged shortcomings in the company’s responses over the years.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a short term rebound in WYNN 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 options 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 Wynn Resorts
The bearish outlook for Wynn Resorts’, at least for the purposes of this trade, is a short term investment 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 February 9 $150 put can be bought for about $0.60 and the February 9 $147 put can be sold for about $0.38. This trade will cost about $0.22 to enter, or $22 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 $22. This loss would be experienced if WYNN is above $150 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 WYNN, the maximum gain is $2.78 ($150 – $147 = $3.00; $3.00 – $0.22 = $2.78). This represents $278 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $22 to open this trade.
That is a potential gain of about 12 times the amount risked in the trade. This trade delivers the maximum gain if WYNN closes below $147 on February 9 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 $22 for this trade in WYNN.