Strength Often Leads to More Strength
Many investors notice stocks making large gains and take the stock off their watchlist. Among individual investors, research finds that there is more comfort in buying new lows than new highs. This could be a costly level of comfort.
When a stock is making new highs, there is buying pressure that is pushing the price up. There is no reason to believe that pressure will change because the price is moving up. It will often require a change in fundamentals to reverse the trend. This is true even after a stock makes a large move as Twilio Inc. (NYSE: TWLO) did.
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After Tripling, the Trend Remains Up
The company has been delivering good news and Market Watch recently reported,
“Twilio Inc. shares had already tripled on the year heading into Tuesday afternoon’s earnings report, but that was just a prelude to a record day on Wednesday that shows growing belief the little-known software company could be a giant in the making.
Twilio stock gained 35.4% [after announcing earnings], easily the best one-day gain in history for the stock, which has now quadrupled on the year.
Twilio offers an essential service to developers who create mobile apps, as its software is used to connect apps to essential functions elsewhere on a device and a company’s ecosystem, mainly dealing with phone calls and messaging.
It is the reason, for example, that you can text or call your Uber driver without actually sharing phone numbers; Uber and Facebook Inc.’s WhatsApp were its biggest customers in 2017, collectively accounting for 14% of its business, according to filings with the Securities and Exchange Commission.
Twilio was a highflier in its first year on Wall Street, 2016, as investors hungry for low-float, high-buzz tech stocks to juke were left with few other options in a down year for initial public offerings from tech unicorns.
After that initial spike dissipated, the San Francisco company seemed to settle into a valuation of $2 billion to $3 billion in 2017. That range has been destroyed this year, with Twilio’s market cap nearly topping $10 billion for the first time Wednesday, closing at a valuation of $9.9 billion.”
The big gains could be purely a function of Twilio’s financial performance. While sales growth usually trends down as companies mature and grow larger, Twilio has managed to accelerate already impressive revenue growth while showing profit by some metrics.
In the most recent quarter, sales grew more than 68% after increasing sales a bit more than 40% in the same quarter a year ago, and reported adjusted profit for the second consecutive quarter and second time in company history.
In an interview with MarketWatch, Chief Executive and co-founder Jeff Lawson Lawson said that the stock spike was due to “the power of our platform business model” and “our usage-based pricing model that scales up.”
“We want to be the platform that every company can use to communicate with their customers across every medium,” Lawson said in largely avoiding a question about how Twilio can maintain its growth rates.
JMP Securities analyst Patrick Walravens compared the company favorably to Amazon.com Inc.’s Amazon Web Services cloud-computing division, in that they both focus on providing tools to developers that are essential to their job, and profiting when those developers’ apps grow large.
“AWS started with three very commoditized products — compute, storage and bandwidth — but then they built layer upon layer on top of that,” the analyst explained.
“Twilio in a very similar way begins with a couple of equally commoditized products, which is voice and messaging, and built a set of more sophisticated tools, and on top of more sophisticated tools they’ve built what is effectively applications.”
“We cover 60 software companies, and if there is one that has the opportunity to become a $10 billion-a-year revenue kind of company, it’s Twilio,” Walravens said.
That kind of excitement could explain the jump in price.
A Trade for Short Term Bulls
As with the ownership of any stock, buying TWLO 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 TWLO
For TWLO, the November 16 options allow a trader to gain exposure to the stock.
A November 16 $83 call option can be bought for about $2.87 and the November 16 $87 call could be sold for about $1.30. This trade would cost $1.57 to open, or $157 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 $157.
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 TWLO the maximum gain is $2.43 ($87 – $83 = $4.00; $4.00 – $1.57 = $2.43). This represents $243 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $157 to open this trade.
That is a potential gain of about 154% 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.