Rumors Can Make and Break Stock Prices
Traders have long known that rumors move stock prices. As Napoleon waged war in Europe, the banker Nathan Mayer Rothschild supposedly said that traders should “buy on the sound of cannons; sell on the sound of trumpets.”
He was speaking of war and he meant that traders should buy at the beginning of the conflict and sell when the winner is known. This saying has been broadly applied to other events. For example, it could apply to a takeover.
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When one company is buying another, ideally the deal can be done in secret. Many announced deals are actually completed in secrecy. There are a number of reasons for that. The secrecy allows both companies to negotiate without outside concerns distorting the valuation discussion.
Secrecy also allows buyers to secure financing in the most efficient manner. When scrutiny is on a potential deal, the publicity could affect the pricing of debt or equity investments needed to finalize the deal.
But, not all deals will be done in secret. Some companies announce their potential deals and sometimes, rumors develop in the market place. In these cases, it can be best to buy the rumor and sell the news, following Rothschild’s idea to buy at the beginning and sell at the end.
A Deal Falls Apart
According to Bloomberg, a Chinese consortium including Hillhouse Capital is planning to drop its pursuit of a takeover of Yum China Holdings Inc., (NYSE: YUMC), the $14 billion operator of KFC restaurants in the world’s most populous nation, people with knowledge of the matter said.
The investor group, which also included KKR & Co. and China’s sovereign wealth fund, has decided not to continue pursuing a deal after its initial proposal was rejected, the people said, asking not to be identified because the information is private.
The stock had jumped on the initial hopes of a deal and is now selling off after the end of the deal.
The consortium judged that Yum China’s business conditions have worsened since its approach, limiting the scope for further negotiations, according to the people. It also deemed that a worsening macroeconomic environment and risks of a trade war between the U.S. and China would make an acquisition more difficult at present, the people said.
Yum! Brands Inc. spun out the Chinese business about two years ago after losing market share amid changing tastes and increased local competition. China’s biggest fast-food operator has struggled to attract younger diners to its Pizza Hut restaurants, despite overhauling its mobile app, upgrading its menu and enlisting celebrities to tout the U.S. brand.
DCP Capital and Baring Private Equity Asia were also part of the Chinese consortium, Bloomberg News reported earlier. Representatives for the investor group and Yum China declined to comment.
Now, the stock has broken long term support and appears to be headed lower.
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 YUMC
For YUMC, we could sell a September 21 $32.50 call for about $0.85 and buy a September 21 $35 call for about $0.18. This trade generates a credit of $0.67, 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 $67. The credit received when the trade is opened, $67 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade in YUMC is about $183. The risk can be 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 ($67).
This trade offers a potential return of about 36% of the amount risked for a holding period that is about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if YUMC is below $32.50 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 $183 for this trade in YUMC.
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.