News Drives the Market, For Now
The holiday season has not been cheerful on Wall Street. There’s been bad news for investors from the Federal Reserve, the White House, Capital Hill and financial centers around the world. The news is one indicator that the bull market has ended.
It’s not really the news that offers an indicator for analysts seeking insights into the direction of the trend. It’s more the reaction to the news. And, lately the news has been bearish for a number of stocks. Among them is VMware (NYSE: DVMT).
Dell’s Tracking Stocks Sends a Message to Investors
In a recent article, Barron’s noted,
Wall Street is not embracing Dell Technologies as the tech conglomerate controlled by Michael Dell and Silver Lake Partners nears a public market debut on Friday.
Investors can effectively purchase Dell’s class C common shares through the Dell tracking stock for VMware. The tracker plunged 26% after an election deadline. Holders had the choice of cash or stock under the terms of the deal approved by tracker holders earlier this month.
The cash election of $120 a share was more appealing than the stock election and the overwhelming majority of holders chose cash. Those who elected cash will get a mix of stock and cash with the cash portion of the transaction capped at $14 billion.
Buyers of the tracker now will get the stock option, which is roughly 1.8 shares of the Dell class C stock for each tracker share.
With the tracker trading at around $76, the implied price of Dell common shares is around $42 ($76 divided by 1.8). That price is just over half the roughly $80 a share value that Dell assumed in the tracker transaction.
At the current tracker price, Dell will be valued at about $31 billion, based on roughly 750 million shares outstanding with about 150 million shares trading publicly. The rest are held by Michael Dell and Silver Lake, which took Dell private in a leveraged buyout in 2013.
Dell made an investment pitch in a conference call last Friday. Tom Sweet, the company’s chief financial officer, lauded Dell’s transformation in recent years and its leading positions in servers and data storage as well as a controlling 81% stake in VMware, whose shares are up $1.77 to $146.76. Dell’s stake in VMware is worth about $47 billion.
Investors aren’t as excited about the Dell story, however, apparently because of concerns about the company’s high core debt of around $35 billion and the outlook for technology spending in 2019. The sharp selloff in the tech sector hasn’t helped sentiment with rivals like IBM ( IBM ) under pressure in recent weeks.
There is no reason to expect a rapid turnaround in the stock based on the longer term chart.
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 DVMT
For DVMT, we could sell a January 18 $80 call for about $3.10 and buy a January 18 $85 call for about $2. This trade generates a credit of $1.10, 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 $110. The credit received when the trade is opened, $110 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade in DVMT is about $390. 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 ($110).
This trade offers a potential return of about 28% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if DVMT is below $80 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 $390 for this trade in DVMT.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.