Sectors Can Boost or Hurt Stocks
In general, academic research shows that individual stock price changes can be explained based largely on how the broad stock market moves and how the individual stock’s sector behaves. Only a small part of a stock’s movement, on average, is based on the company.
That means we should be prepared to see most stocks rise in a bull market and most stocks fall in a bear market. Furthermore, that means stocks in top performing sectors are likely to be the biggest gainers in the market and stocks in the worst performing sectors are likely to be market laggards.
This means we can start analyzing a trade based on what a company does.
A Top Down Approach to Trade Selection
TAL Education Group (NYSE: TAL) is a holding company for a group of companies engaged in provision of after-school tutoring programs for primary and secondary school students in the People’s Republic of China (the PRC).
This already tells us something important. This is a company based in China and that country is in a bear market. The benchmark Shanghai Composite Index is shown below.
Digging deeper into the company’s description confirms its role in education.
The Company is a K-12 after-school tutoring services provider in China. The Company’s Xueersi Peiyou small classes course consists of approximately four semesters, which include approximately two school semesters in Spring and Fall, and approximately two holiday semesters in summer and winter.
It operates a Website, www.jzb.com, which is an online education platform in China. It offers personalized premium services under its Zhikang brand. It offers online courses through www.xueersi.com.
The Company has over 10 call centers in Beijing, Shanghai, Tianjin, Guangzhou and Shenzhen.
Education stocks tend to be market laggards. This is also important information. We can look for bearish trades in TAL, assuming we have a short term catalyst in the stock.
Earnings Provide a Catalyst
PR Newswire reported, “TAL Education Group…announced its unaudited financial results for the second quarter of fiscal year 2019 ended August 31, 2018.
Net revenues increased by 53.5% year-over-year to US$699.8 million from US$455.8 million in the same period of the prior year.
Income from operations increased by 18.4% to US$80.9 million from US$68.3 million in the same period of the prior year.
Non-GAAP income from operations increased by 23.8% to US$99.0 million from US$79.9 million in the same period of the prior year.
Net income attributable to TAL increased by 29.5% year-over-year to US$77.0 million, from US$59.5 million in the same period of the prior year.
Non-GAAP net income attributable to TAL, which excluded share-based compensation expenses, increased by 33.8% to US$95.1 million from US$71.1 million in the same period of the prior year.
Total student enrollments increased by 120.2% year-over-year to approximately 4,937,320 from approximately 2,242,380 in the same period of the prior year.”
We can look to the market reaction to see what to make of the news. The stock rallied on the news.
The longer term chart shows TAL could be bouncing off of support.
We see short term optimism in a stock that is in a long term down trend. The longer term trend means volatility is high and the short term provides a bullish set up, assuming we can limit risk.
A Trade for Short Term Bulls
As with the ownership of any stock, buying TAL could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for TAL
For TAL, the November 16 options allow a trader to gain exposure to the stock.
A November 16 $28 call option can be bought for about $0.67 and the November 16 $30 call could be sold for about $0.33. This trade would cost $0.34 to open, or $34 since each contract covers 100 shares of stock.
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 $34.
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 TAL the maximum gain is $1.66 ($30 – $28 = $2.00; $2.00 – $0.34 = $1.66) This represents $166 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $34 to open this trade.
That is a potential gain of about 488% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.