This Company Might Have Two Strikes Against It
In the broad market, it can help a company if it has a tailwind or macro trends that are pushing the company’s industry towards success. On the other hand, facing headwinds or macro trends that are pushing against success can be a large problem.
Headwinds can come from the broad economy, especially when it is slowing. Headwinds could also affect specific industries and the companies within that industry then face challenges trying to rally. Or, headwinds can be associated with geography with some countries or regions facing a slowdown.
For some companies, it’s possible to face multiple headwinds. That’s the case for New Oriental Education & Technology Group Inc. (NYSE: EDU).
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Country and Industry Headwinds
EDU is a provider of private educational services in the People’s Republic of China. The company provides educational services under its New Oriental brand, operating in seven major areas: language training and test preparation, primary and secondary school education, online education, content development and distribution, pre-school education, overseas study consulting services and study tour.
The company offers a range of educational programs, services and products, consisting of English and other foreign language training, test preparation courses for admissions and assessment tests in the United States, the People’s Republic of China and Commonwealth countries, primary and secondary school education, development and distribution of educational content, software and other technology, and online education.
EDU recently announced earnings and according to Associated Press:
“[the company] reported fiscal first-quarter net income of $123.2 million.
The Beijing based company said it had profit of 77 cents per share. Earnings, adjusted for non-recurring costs and stock option expense, were $1.16 per share.
The educational services provider posted revenue of $859.8 million in the period.
For the current quarter ending in December, New Oriental said it expects revenue in the range of $568.5 million to $586.4 million.
New Oriental shares have fallen 33 percent since the beginning of the year. The stock has declined 32 percent in the last 12 months.”
Traders sold on the news. They seem to be rapidly pricing in concerns related to the company’s future prospects.
This sell off comes as the stock is in a down trend. In part, the trend reflects weakness in Chinese stocks and concerns American investors have about transparency into accounting procedures of companies in that country. In part, it is also due to weakness in the education industry as the economy slows.
The charts show support could be found near $40 a share, well below the current price. This means it could be best to avoid buying the stock and instead focus on strategies that are profitable if the price declines.
A Trading Strategy to Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
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 traders can consider is the bear call spread. This is a trade that 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. The call is sold to limit the risk of the trade. So this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It 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 and is also known.
A Bear Call Spread in EDU
For EDU, we could sell a November 16 $55 call for about $2 and buy a November 16 $60 call for about $0.67. This trade generates a credit of $1.33, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $133. The credit received when the trade is opened, $133 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $367. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($133).
This trade offers a potential return of about 36% of the amount risked for a holding period that is about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if EDU is below $55 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 $367 for this trade in EDU.
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.