Short Covering Could Explain This Stock’s Rise
There are times when analysts and traders all move to one of side of the boat, so to speak. As investors who have been on small boats know, it is best to keep the load balanced. If everyone moves to the same side, the boat tips.
A similar idea can be applied to the stock market. When too many traders are one side of the trade, the trade is too crowded and could tip over. In the stock market, the tip over can take the form of a sharp reversal.
An example of a stock that seemed to reach a tipping point can be seen in the chart of Cree, Inc. (Nasdaq: CREE).
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Earnings Spark a Rally
Bloomberg analysts noted,
“It turns out that investors who were short shares of Cree Inc. and may have covered their positions yesterday were right to worry.
The semiconductor and lighting company jumped more than 5 percent, rising a fourth day, after beating first quarter estimates. Today’s gain comes on the heels of yesterday’s bump, which some analysts attributed to short covering by investors ahead of Cree’s earnings report. Cree is outperforming the Philadelphia Semiconductor Index (SOX) index for a second day.”
“Over the last several weeks, there has been a bear call in Cree and the premise is that the market outlook and implied revenue for Cree is a top,” Roth Capital analyst Craig Irwin said in a phone interview yesterday. “They’re just dead wrong.”
Irwin was correct. Cowen’s Jeffrey Osborne also noted that short sellers may have been getting nervous about the potential for a stronger-than-expected earnings report.
The 10-day average days-to-cover, according to financial analytics firm S3 Partners, stood at nearly 9 days on Tuesday and a high number typically can expose a stock to potential short squeezes.
By contrast, lighting peer Acuity Brands Inc.’s days-to-cover stands at 3, while SOX component Lam Research Corp., the second-best performer Wednesday after its results, has a days-to-cover figure closer to 3.5.
Irwin isn’t alone in saying that investors and analysts may be wrong about Cree.
“We feel the true magnitude of the company’s exciting EV and 5G opportunities may not be fully captured in our or Street estimates yet,” wrote Piper Jaffray’s Harsh Kumar in a note following the results. He rates Cree an equivalent of neutral with a $45 price target.
Both Irwin and Kumar note that the power-semiconductor industry, a $400 billion global market today, might be on the verge of momentous change, as silicon-carbide (SiC) becomes more important to the largely silicon-based market.
“We feel Cree has some very interesting Silicon Carbide materials” and their “technology is hard to replicate at the materials level,” Kumar wrote. “Cree could easily outperform the broader semiconductor market over the next 5-7 years given the opportunity SiC presents.”
The weekly chart shows that CREE could have been set up for at least a short term bounce after a steep decline.
A Trade for Short Term Bulls
As with the ownership of any stock, buying CREE 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 CREE
For CREE, the November 16 options allow a trader to gain exposure to the stock.
A November 16 $37 call option can be bought for about $1.10 and the November 16 $39 call could be sold for about $0.46. This trade would cost $0.64 to open, or $64 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 $64.
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 CREE the maximum gain is $1.36 ($43 – $41 = $2.00; $2.00 – $0.64 = $1.36). This represents $136 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $64 to open this trade.
That is a potential gain of about 212% 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.