Slow Moves Can Be Profitable
Traders often seek out the action. They may scan the list of stocks that are the most active or the list of the biggest movers. There are a number of trading strategies that can be applied to stocks that show up on the list of biggest gainers or biggest losers every day.
But, doing this means missing the stocks that make slow moves. These stocks might not seem very interesting but they could also deliver gains to traders who use the right strategies. There are actually a number of strategies that could be used with slow moving stocks in pursuit of profits.
Historically, one of the stocks best known for slow moves is Altria Group (NYSE: MO). This stock has a beat of 0.44, an indicator that its price moves are significantly smaller than average. In fact, the beta tells us to expect MO to move just 44% as much as the S&P 500.
So, if the S&P 500 gains 10%, we would MO to move up just 4.4%. This is a slow moving stock but it pays a regular and rather large dividend. Because of that dividend, the stock has been of the biggest winners of all time on Wall Street.
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An Earnings Report Confirms Slow Growth for MO
In its most recent earnings report, MO affirmed the outlook for continued slow growth.
The company did deliver better than expected earnings. Earnings per share (EPS) of $0.90 were three cents better than the analysts’ consensus forecast.
Analysts are usually employees of major Wall Street firms assigned by their company to follow a company. They research the company to develop detailed financial models that are used to forecast expected earnings. The detailed model is also used to develop price targets for the stocks.
The consensus forecast is the average of the different analysts’ estimates. These forecasts are published by several data providers who collect the individual estimates.
Earnings announcements will also generally include comments from the company’s management. In the case of MO, the comments were largely bullish.
“Altria delivered outstanding performance in the third quarter and for the first nine months of 2017 as our core tobacco operating companies generated strong income growth,” said Marty Barrington, Altria’s Chairman, Chief Executive Officer and President.
He noted, “Our financial performance continues to strengthen in the second half, as we expected.”
“And we continued to focus on rewarding shareholders through the first nine months, paying out more than $3.5 billion in dividends and repurchasing nearly $2.4 billion in shares. In August, Altria’s Board of Directors voted to increase our quarterly dividend per share by 8.2%.”
“The business is performing well in a competitive environment, and we continue to expect full-year adjusted diluted EPS growth of 7.5% to 9.5%.”
The announcement also reaffirmed the outlook for the full year. Altria expects full-year earnings in the range of $3.26 to $3.32 per share. Analysts expect the company to report EPS of $3.27, near the low end of management guidance.
Fair Value For MO Could Push the Stock Lower
Given its slow growth, it is safe to assume that investors value MO for its divided. We can use the dividend to find the fair value of the stock.
Over the past seven years, MO has traded with an average dividend yield of 5%. This average can be used to find the stock’s fair value.
Fundamental ratios like the dividend yield or the price to earnings (P/E) tend to be mean reverting. That means they will move above and below the long term average which acts like a magnet for the ratios.
That principle of mean reversion for fundamental ratios is the basis of Nobel Prize winning economist Robert Shiller’s popular CAPE ratio valuation model.
MO’s current dividend is now $2.64 per share per year. Dividing the current dividend by the long term average dividend yield ($2.64 / 0.05) provides a price target of $52.08. Based on the fair value, there is significant downside in the stock.
The Stock’s Trend is Down
The chart below shows the recent price action in MO. The trend is clearly down and the recent earnings report seems unlikely to be enough to reverse that trend.
To benefit from weakness, an investor could buy put options. But, as the chart shows, MO has been in a downtrend and that has resulted in increased volatility. The higher volatility increased options premiums even more. This is normal behavior when a sell off occurs.
But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility. In this case, with a bearish outlook, a call option should be sold.
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 is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below:
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in MO
For MO, we have a number of options available. Short term options allow us to trade frequently and potentially grow our account size quickly.
In this case, we could sell a November 17 $67 call for about $0.50 and buy a November 17 $69 call for about $0.15. This trade generates a credit of $0.35, which is the difference in the amount of premium for the call that is sold and the call. Since each contract covers 100 shares, opening this position results in immediate income of $35.
The credit received when the trade is opened, $35 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $165. The risk is found by subtracting the difference in the strike prices ($200 or $2.00 time 100 since each contract covers 100 shares) and then subtracting the premium received ($35).
This trade offers a return of about 21% for a holding period that is less than three weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if MO is below $67 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 $165 for this trade in MO.
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