The Uncertainty Is Lifted From This Stock
It’s often said that traders hate uncertainty. This means that news can be priced into a stock. Whether it is good or bad news, traders can assess the impact of the facts on a company’s value and the stock can trade in line with that impact.
But, sometimes all that’s certain is uncertainty. Technical analysts often point to certain price levels on charts as times when uncertainty will rise. One example of that is a pattern called “overhead supply.”
Sometimes, a stock rallies sharply and then reverses suddenly. If the reversal brings prices down by a large amount, there could be a large number of traders with losses. These would be the traders who bought the stock near the end of the rally.
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Now, many investors who suffer a loss will wait until they break even to sell. This is so well known it even has a name, breakevenitis.
Technical analysts call this overhead supply. They see that there are a large number of buyers who took positions right before the decline began. They assume many will sell when they can get out with a small loss or when they breakeven. Their shares represent potential supply that is over head of the current price.
Sometimes, the overhead supply is created by a fundamental factor. That was the case recently for a casino stock.
Wynn’s Largest Shareholder Faces Problems
The question of potential overhead supply loomed over Wynn Resorts, Limited (Nasdaq: WYNN) after its founder, Steve Wynn, captured negative headlines.
In late January, The Wall Street Journal reported that “Dozens of People Recount Pattern of Sexual Misconduct by Las Vegas Mogul Steve Wynn.” The article reported a pattern of inappropriate behavior by the founder that occurred over years.
In February, Wynn resigned as CEO and Chairman of the Board of Directors. But, traders were concerned about his share holdings. Wynn was the largest share holder in the company.
Now, The Wall Street Journal is reporting that Wynn has sold all of his shares. “Steve Wynn sold his entire stake…on Wednesday and Thursday, the company said, the final step in a dramatic exit after female employees made allegations of sexual misconduct against the casino giant’s co-founder.
The sale of $2.1 billion worth of stock over two days followed a series of moves he and the company made in recent weeks to allow Mr. Wynn to untangle himself from the casino corporation amid a series of investigations by state gambling regulators.
Until Wednesday, Mr. Wynn had been the company’s largest shareholder, owning about 12% of its stock.
That day Mr. Wynn sold 4,104,999 shares of common stock in open market transactions at $180 a share, Wynn Resorts said in a Thursday filing, for a combined $738.9 million. Wynn Resorts had said earlier on Wednesday that Mr. Wynn “intends to sell all or a portion” of his stock.
On Thursday evening the company said two existing institutional shareholders purchased Mr. Wynn’s remaining 8 million shares, for a combined $1.4 billion.”
This clears the overhead supply and the stock rallied on the news.
The stock could now rally back towards its recent highs with this concern out of the way.
A Trade for Short Term Bulls
As with the ownership of any stock, buying WYNN 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.
A Specific Trade for WYNN
For WYNN, the April 20 options allow a trader to gain exposure to the stock.
An April 20 $185 call option can be bought for about $6.00 and the April 20 $187.50 call could be sold for about $4.50. This trade would cost $1.50 to open, or $150 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 $150.
The maximm 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 WYNN the maximum gain is $1.00 ($187.50 – $185 = $2.50; $2.50 – $1.50 = $1.00). This represents $100 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $150 to open this trade.
That is a potential gain of more than 66% 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.