The Best Trade in GE
General Electric (NYSE: GE) seems to be fighting for survival. This is an amazing story for the storied company which has survived economic turmoil for more than a century. The company is hoping to save itself by selling off assets.
That includes this week’s sale of what Bloomberg called, “a bundle of health-care information-technology businesses to private equity firm Veritas Capital for $1.05 billion in cash.”
Analysts noted this divestiture makes sense for at least two reasons. First, GE has struggled to make its mark in a crowded market for health-care workforce management and billing software, so investors won’t miss this business.
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Second is the fact that Veritas is paying cash really should be underscored in a bright color in light of continuing fears about a liquidity crunch at GE and the risk of a credit-rating downgrade.
Even after this sale, GE remains a diverse collection of unrelated businesses.
While the company is unlikely to generate profits from this varied collection of revenue centers, it might need to sell them off slowly.
JPMorgan Chase & Co. analyst Steve Tusa estimates GE will lose $1.5 billion to $2 billion of free cash flow through its targeted $20 billion in asset sales, dragging the normalized level meaningfully lower than the $6 billion to $7 billion that GE is targeting for 2018.
In other words, GE is a conglomerate that shouldn’t exist but might need to exist for the time being. That’s because GE’s only way out of this mess is probably a long slow grind of asset trimming and operational improvements.
The Stock’s Likely Course
After the sharp decline of the past few months, GE could be tempting to value investors. They may see the company as a bargain because it has been in business for so long and could reasonably be expected to survive in some form.
While the long term chart does show a clear down trend, there is nothing on the chart to indicate that is set to reverse. Buying now could be compared to trying to catch a falling knife since the odds of success are not very high based on the stock’s trajectory.
The shorter term chart also shows no reason to expect a reversal.
But, traders can expect a large move in the stock price over the next few weeks. The company is set to announce its latest quarterly earnings on April 20. The stock should be volatile on that day. That provides an opportunity to benefit from the volatility without making a directional trade.
In the earnings announcement, the company is an all honesty equally likely to deliver news that is bullish or bearish. There could be more divestures, or there could be an improvement in the business of one of the company’s divisions.
Of course, there could also be more disappointments, or at least no news that hints of a near term turn in the company’s fortunes.
Whether the news is good or bad, the stock is likely to make a relatively large move that day. The likelihood of volatility is increased because the earnings coincides with options expiration, the day that monthly options expire and that day is usually volatile.
Volatility Seems Certain
When we expect volatility, but cannot forecast the direction of the price move, a long straddle can be used. This strategy is a combination of buying a call and buying a put, both with the same exercise price and expiration date.
Together, these two options contracts create a position that should profit if the stock makes a big move either up or down.
The strategy hopes to capture a quick increase in implied volatility or a big move in the underlying stock price during the life of the options. The risks are known when the trade is opened and the potential gains can be large. This is shown in the diagram below.
Source: The Options Industry Council
The maximum gain on a straddle is, in theory, unlimited. The profit at the expiration date of the options will be the difference between the stock’s price and the strike price, less the premium paid for both options. There is no limit to profit potential on the upside, while the downside profit potential is limited only because the stock price cannot go below zero.
The maximum loss is limited to the amount of premiums paid to open the position. The worst that can happen for a trader with a straddle position is that the stock price holds steady. If the stock’s price on the expiration date is exactly equal to the exercise price of the options, the options expire worthless, and the entire premium paid to put on the position will be lost.
A Specific Trade in GE
To trade this idea, we could trade options on General Electric.
The straddle can be opened using options expiring on April 20 with an exercise price of $13. The April 20 $13 call is trading at about $0.50. The April 20 $13 put is trading at about $0.50. The total cost to open the trade is about $1.00, before commissions which should be relatively small at a deep discount broker.
The total premiums add up to about 8% of the price of GE. The question is whether or not a move of that size is likely within the next few weeks. Given the current state of the market, it seems safe to assume that a significant price move is likely. Whether that move is up or down, this trade could profit.
The long straddle is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide the potential for gains and defined risk that could be lower than owning the stock. This strategy should also have a high probability of success.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.