This Chart Pattern Shows Potential Problems
If we are in a bear market, it is almost certain that a majority of stocks will fall. Several studies have found that this is the case and many examples of data demonstrate the problem of betting against the direction of the larger trend.
On a day when the major stock market averages all close higher, a look at the advance decline data or drilling down into volume data will usually reveal most stocks moved up and most of the volume was to the up side. The opposite holds on down days.
So in a bear market we should expect most stocks to decline but some will fall more than others. They will often be ones that deliver bad news and display a sharp gap down on the news.
An Example of How Bad News Could Affect a Stock
The Wall Street Journal recently reported,
America’s Economy Could Be In For A Rude Awakening
If you’re worried about why stocks are surging while millions of Americans are out of work and commercial bankruptcies are skyrocketing, I strongly urge you to listen to this message.
Constellation shares, which had gained 7% so far this year before the news, were down 10% immediately after the announcement.
“The company said profit dropped almost 39% to $303 million, or $1.56 a share, in the quarter. Constellation reported a $135 million loss from investments that weighed on results, lowering net income before taxes. Analysts polled by FactSet expected $2.06 a share.
Constellation also lowered its profit outlook for its 2019 fiscal year, saying Wednesday it now expects earnings of $12.95 to $13.05 a share. Previously, it guided to a profit of $14.10 to $14.25 a share for the year.
“For the wine and spirits business, the company now expects net sales and operating income to decline low-single digits,” Constellation said.
The company said it lower the fair value of its investment in Canadian marijuana supplier Canopy Growth Corp. by $164 million.
Best known for brands such as Corona beer, Constellation made investments in Canopy, including a $4 billion investment last year, anticipating growing consumer demand for products infused with the substance.
Beer sales were up 16% from a year earlier to $1.21 billion in the quarter ended Nov. 30, Constellation said Wednesday. The operating margin in the beer business ticked down to about 37%, as the company grappled with higher transportation and operational costs, and increased investments in marketing.
Constellation said wine sales were slower, increasing 1% to $670.3 million. The company’s spirits business generated sales of $92.5 million in the quarter, compared with $92.8 million a year ago.
Overall, sales rose almost 10% to $1.97 billion. Analysts predicted $1.91 billion, according to FactSet.
This news confirms the down trend in the stock could have more to go.
A Trading Strategy to Benefit From Potential Weakness
The prospects of a further short-term gains in STZ 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 STZ
The bearish outlook for STZ, 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 January 18 $157.50 put can be bought for about $4.15 and the January 18 $162.50 put can be sold for about $6.70. This trade will cost about $2.55 to enter, or $255 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 $255. This loss would be experienced if STZ is above $157.50 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 STZ, the maximum gain is $2.45 ($162.50 – $157.50 = $5; $5 – $2.55 = $2.45). This represents $245 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $255 to open this trade.
That is a potential gain of about 96% of the amount risked in the trade. This trade delivers the maximum gain if STZ closes below $162.50 on January 18 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 $255 for this trade in STZ.