Talcum Powder and Asbestos Create This Trading Opportunity
Technical analysts believe that prices move in trends. Efficient market proponents believe that trends are caused by news. Combining the two ideas we could say we expect news to trend and for this company the recent trend in news has been bearish.
Bloomberg reported the latest bit of bad news,
“Johnson & Johnson (NYSE: JNJ) is recalling one lot of its Johnson’s Baby Powder after tiny amounts of asbestos contamination were found in samples from a single bottle purchased online.
J&J is voluntarily recalling the lot, #22318RB, which consists of 33,000 bottles, and is encouraging people who bought the product to discontinue use. The company said that it is working with the Food and Drug Administration, which tested the bottle, and has started an investigation into how and when the product was contaminated.
FDA spokeswoman Gloria Sanchez-Contreras said the contaminated bottle contained chrysotile fibers, a type of asbestos. The FDA recommended that consumers stop using the lot immediately and contact J&J for a refund. Another lot of Johnson’s Baby Powder the FDA tested was negative for asbestos, the agency said in a statement.
J&J shares fell 6.2% [on the day the news was released], the biggest drop since December 2018. The stock has been under pressure as investors try to ascertain the company’s potential liabilities in a series of lawsuits related to talc and other products.
“Thousands of tests over the past 40 years repeatedly confirm that our consumer talc products do not contain asbestos,” J&J said in a statement [after the news was released].
J&J is looking into whether cross-contamination of the sample caused a false positive, whether the product was appropriately sealed and maintained in a controlled environment, and whether the product was a counterfeit.
Sanchez-Contreras said the FDA “stands by the quality of its testing and results and is not aware of any adverse events relating to exposure to the lot of affected products.” The FDA has tested about 50 cosmetic products for asbestos since 2018 and plans to release the full results by the end of this year, the agency said.
During a brief call with investors …, J&J global supply chain and women’s health executives said they had received the product’s test results the previous day and acted promptly to inform the public. The investigation could take 30 days or more, they said.
The executives didn’t take questions from participants on the call.”
The chart below shows that bad news has sent JNJ lower several times in recent months.
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.
Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
A Bear Call Spread in JNJ
For JNJ, we could sell a November 15 $130 call for about $1.99 and buy a November 15 $135 call for about $0.58. This trade generates a credit of $1.41, 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 $141. The credit received when the trade is opened, $141 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $359. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($141).
This trade offers a potential return of about 39% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if JNJ is below $130 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 $359 for this trade in JNJ.