The Chart Foretold This Price Move
Some market analysts often like to say a price move is unexpected. Technical analysts will often say that the size of a price move can be difficult to forecast but the direction is usually in line with the chart pattern.
That’s simply because the chart pattern shows the action of traders. The chart isn’t really doing anything except recording the history of buying and selling. Traders tend to buy and sell as a group with a herd mentality.
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With herding, we see a large group of traders buying or selling at the same time. The behavior is often in response to news. That was the case with Seagate Technology PLC (Nasdaq: STX) recently.
A Downgrade Sparks a Rush to the Exit
Traders often speak in ways that attempt to explain behavior with easy to understand concepts drawn from everyday activities. At times, when there is heavy selling, traders note that there is a rush for the exits.
Just like in a building, the exit tends to be a narrow opening and the buildup near the door creates pressure on the mass of people trying to squeeze through. In the stock market, the mass of pressure shows up as a large move down.
For STX, the rush to the exit began with a downgrade from an analyst. According to Market Watch, “Evercore ISI analyst C.J. Muse downgraded the stock to underperform from in-line and lowered his target price to $45 from $55.
“We…believe the market has gotten a bit complacent around NAND pricing, especially with respect to demand elasticity for NAND driving increasing [hard-disk drive] cannibalization,” Muse wrote.
He sees downside risk for the company given his expectations for flattish top-line growth “at best,” falling gross margins, and lower-than-expected NAND prices. He worries about mix shift as well.
In addition to lowering his outlook for STX, Muse also downgraded the shares of Western Digital Corp., a competitor, to in-line from outperform, also citing NAND pricing declines.
The report resulted in a sell off that lowered the price of STX as much as 10% within hours of the report’s release.
Traders could see a clear down trend in the chart with STX repeatedly failing to break to new highs since April. The longer term chart confirms the bearish outlook.
This chart shows a rounding pattern, a type of chart pattern that is common at significant tops. The rounding pattern shows an absence of buyers. In that environment, the slightest bit of bad news could spark a rush for the exits as STX demonstrated. Now, the trade setup is completed.
A Trading Strategy to Benefit from Potential Weakness
The prospects of further short-term gains in STX seem to be remote. But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for STX
The bearish outlook for STX, at least for the purposes of this trade, is a short-term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the September 21 $53 put can be bought for about $5.02 and the September 21 $49 put can be sold for about $1.97. This trade will cost about $3.05 to enter, or $305 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
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 $305. This loss would be experienced if STX is above $53 when the options expire. In that case, both options would expire worthless.
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 STX, the maximum gain is $0.95 ($53 – $49 = $4; $4 – $3.05 = $0.95). This represents $95 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $305 to open this trade.
That is a potential gain of about 31% of the amount risked in the trade. This trade delivers the maximum gain if STX closes below $49 on September 21 when the options expire.
Put 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 $305 for this trade in STX.