Play It Safe With This Stock
Stocks have been volatile this past week and all major stock market averages completed their first pullback in more than a year. A pullback is generally defined as a 5% decline from a previous high. Some indexes even completed corrections in the past week.
A market correction is generally defined as a decline of at least 10%. The Dow Jones Industrial Average, the Russell 2000 and several other averages all declined at least 10% before they rebounded. The gains in the indexes have been almost as fast as the declines.
This leaves many investors asking, “was that it?” It seems like one week of selling is an unusually short correction and traders are wondering if there is more downside. That question makes sense since the recent run up was the longest on record without so much as a 5% pullback.
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With the possibility of a new bull market seemingly equal to the probability of further declines, investors are right to be wary. That means it could be a good time to take trades that have a high likelihood of benefitting from declines in individual stocks no matter what the broad stock market does.
One stock that seems unlikely to move higher in the near term is Chipotle Mexican Grill (NYSE: CMG).
An Earnings Beat Failed to Impress Investors
Chipotle reported earnings that beat quarterly earnings estimates but analysts were quick to point out that the beat was attributable to a large benefit the company will see from the recent changes to tax rules.
There was speculation that the selling seen in the stock after the report could be due to that fact that traders were disappointed by low same store sales growth and adverse effects of cost inflation the company could see in the coming year.
There was finally some good news for the company. Earnings per share (EPS) came in at $1.55, after a relatively large $0.21 per share benefit from tax cuts. Same store sales growth of 0.9% was better than the 0.7% that analysts had been expecting.
The company noted that same store sales was helped by customers adding the recently launched side of queso to their orders.
According to Barron’s, “Growth could pick up slightly in the quarters ahead, but costs are a concern.” Management sees same-store sales rising by a low-single-digit percentage in 2018. The consensus forecast is 3.2%.
Management also expects store-level profit margins to come in at 17.5% to 18.5%. The consensus is at the high end, but WeCMGush Securities analyst Nick Setyan is forecasting store margin of 17.5%, at the low end of guidance.
In a Wednesday note, Setyan attributed his restrained view on margins to “the lack of a meaningful transaction recovery,” coming up against mid-single-digit labor inflation and 2% to 3% food inflation.”
Finally traders could be concerned that current trends will remain in place for an extended period of time.
The company is expected to name a new CEO soon. But, according to reports, one thing its CEO of the past 25 years doesn’t expect this new person to change is the restaurant company’s mission statement or culture. That means more of the same is likely for some time.
Chipotle founder and current CEO Steve Ells said the committee searching for the company’s next executive — a committee that includes himself and two other board members — does not have a time frame yet for naming his successor.
Traders would clearly like some change that could reverse the stock’s trend.
But, that is unlikely with the stock hitting new lows.
A Trading Strategy to Benefit From Potential Weakness
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 trading strategies 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 Chipotle
The bearish outlook for Chipotle, 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 options 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 16 $255 put can be bought for about $1.90 and the February 16 $250 put can be sold for about $1.10. This trade will cost about $0.80 to enter, or $80 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 $80. This loss would be experienced if CMG is above $255 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 CMG, the maximum gain is $4.20 ($255 – $250 = $5.00; $5.00 – $0.80 = $4.20). This represents $420 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $80 to open this trade.
That is a potential gain of about 425% of the amount risked in the trade. This trade delivers the maximum gain if CMG closes below $250 on February 16 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 $80 for this trade in CMG.