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Overreactions Fuel a Trading Strategy

Overreactions Fuel a Trading Strategy

This year’s Nobel Prize in Economics went to Dr. Richard Thaler, an economist who has studied the stock market. While many economists study the stock market, Thaler’s work is different. He studies how traders actually behave instead of assuming that traders are rational as many economists do.

Because he focuses on the real market action instead of theoretical models, Thaler’s work has resulted in a number of important insights. He has proven that traders tend to overreact at times. While this might not sound like a major insight to market participants, it disrupts decades of academic research.

Academic researchers have long assumed that market reactions to events like earnings announcements are instantaneous reappraisals of a company’s prospects. Thaler demonstrated the large moves are an overreaction to the news sparked by fear and greed.

One of the more interesting aspects of Thaler’s work is the fact that we can develop trading strategies based on his ideas. For example, when there is a large market move based on an earnings announcement, it could be an overreaction.

To spot overreactions, we could consider the fundamentals. If the stock is overvalued and rallies sharply on the news to become more overvalued, it’s likely a pull back is set to occur. The probability of this increases if there is a recurring pattern of pull backs after earnings announcement.

A Look at the News on GrubHub

After announcing its latest quarterly results, the stock price of GrubHub Inc. (Nasdaq: GRUB) soared. Both earnings and revenue topped analysts’ expectations. Analysts are often employed by Wall Street firms to follow a company and prepare estimates of the company’s financial performance.

Data services then collect these estimates and publish an average of the results. The average is known as the consensus estimate and traders tend to anchor their expectations on that value. If a company beats expectations, the stock price often moves higher. That’s what happened to GRUB.

The company reported earnings per share (EPS) of $0.28. This was $0.04 better than the average of the estimates published by the 21 analysts who cover the stock. GRUB reported revenue of $163.1 million, easily beating analysts’ expectations of $159.7 million.

Looking ahead, GrubHub said it expects revenue of $197 million to $205 million for the quarter ending December. This guidance was higher than analysts’ estimate which had been for revenue of $183.8 million in the last three months of the year.

Digging deeper into the report, we see the company is growing rapidly. GrubHub said it had 9.81 million active diners in the quarter ended Sept. 30, up nearly 28% from a year earlier. This also topped analysts’ average estimate which called for 9.57 million diners, according to the research firm FactSet.

GRUB sold $867 million worth of food in the third quarter to 9.81 million customers. Those sales were up 18% from the same period a year earlier, while diners jumped 28% year over year. Growth appears to be continuing at a steady pace.

Overreactions Fuel a Trading Strategy

Source: Quartz.com

The growth seems to have been fueled, at least in part, by the acquisition earlier this year of Yelp Inc’s online food delivery platform Eat24, adding to a list of acquisitions that include Foodler Inc and OrderUp.

The growth in sales, however, has been much faster than growth in earnings.

Overreactions Fuel a Trading Strategy

Source: Quartz.com

This leads to questions about the company’s stock price and standard tools suggest the stock is overvalued. The price to earnings (P/E) ratio of 80 indicates the stock is overvalued when the average stock is trading with a P/E ratio of about 20.

A Trading Strategy to Benefit From Potential Weakness

GRUB has a tendency to sell off in the weeks after reporting earnings. It seems to follow a pattern of overreaction where investors bid the price up before profit taking sets in.

However, even if the stock doesn’t decline much, in the short term, GRUB seems unlikely to rally sharply. Traders will most likely want to see proof the company can grow into its outsized valuation and they will most likely be watching for signs of progress in that next earnings report.

This means traders should consider using an options trading strategies known as a bear put spread to benefit from the expected 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.

Overreactions Fuel a Trading Strategy

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 GRUB

The bearish outlook for GRUB, 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 November 17 $55 put can be bought for about $2.00 and the November 17 $52.50 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 spend to open the trade, or $100. This loss would be experienced if GRUB is above $55 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 GRUB, the maximum gain is $1.50 ($55 – $52.50 = $2.50; $2.50 – $1.00 = $1.50). This represents $150 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 150% on the amount risked in the trade. This trade delivers the maximum gain if GRUB closes below $52.50 on November 17 when the options expire. There is a relatively low probability of that according to the options pricing models.

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 GRUB.

You can find more trades like this in the Trading Tips service, Options Cash Cow. To learn more, click here.