The One Trade You Need in This Market
On Wednesday, it was Amazon.com. According to news reports, “Capitol Hill wants Facebook’s blood, but President Trump isn’t interested. Instead, the tech behemoth Trump wants to go after is Amazon. “He’s obsessed with Amazon,” a source said.”
Sources indicate Trump has talked about changing Amazon’s tax treatment because he’s worried about mom-and-pop retailers being put out of business. And the concerns seem unlikely to go away:
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“Behind the president’s thinking: Trump’s wealthy friends tell him Amazon is destroying their businesses. His real estate buddies tell him — and he agrees — that Amazon is killing shopping malls and brick-and-mortar retailers.”
On the other hand, Vice President Mike Pence is concerned about Facebook and Google, according to a source with direct knowledge. Though Pence isn’t yet pushing internally for any specific regulations, he argues these companies are dangerously powerful.
The source said the V.P. worries about their influence on media coverage, as well as their control of the advertising industry and users’ personal info. When private discussions have turned to the idea of busting Facebook and Google, Pence has listened with keen interest and is open to the suggestion that these two companies need shaking up.
Tech Woes Seem Unlikely to Change
While the focus of which tech stock is a potential problem changes from day to day, news is starting to weigh on the sector. And, that seems unlikely to change in the near term. Tech companies have made missteps in the past year that fuel critics.
For traders, it could be profitable to find the company in the headlines and trade the stock based on expectations of a decline. Of course, options allow traders to benefit from an increase or decrease in price or even from a trading range.
However, options will all expire and that makes it important to determine not only which company will sell off but also when. If the timing is off, the option could expire without delivering a profit to the trader, even when they are right on the trade idea.
To minimize the risk of this problem, traders could consider PowerShares QQQ ETF (Nasdaq: QQQ), an ETF that tracks the large cap tech stocks in the Nasdaq 100 index. The ten largest holdings of the ETF are shown below.
On any given day, there will be some large movers in the Nasdaq 100 and the general trend in the individual components has been down. In fact, the index seems to be leading the market to the downside, which is not surprising given its components.
In the short run, there is unlikely to be a significant rally in QQQ. It will take time for traders to gain confidence that the sector is recovering from its problems. That creates a trading opportunity.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. 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 QQQ
For QQQ, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell an April 6 $160 call for about $2.00 and buy an April 6 $160.50 call for about $1.80. This trade generates a credit of $0.20, 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 $0.20. The credit received when the trade is opened, $0.20 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $30. The risk is found by subtracting the difference in the strike prices ($50 or $0.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($20).
This trade offers a potential return of about 66% of the amount risked for a holding period that is about one week. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if QQQ is below $160 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 $30 for this trade in QQQ.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.