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This Downgrade Could Create a 66% Income Opportunity

This Downgrade Could Create a 66% Income Opportunity

Analyst downgrades attract attention to stocks and that can help traders spot opportunities that might not be apparent at first glance. In recent news, as Benzinga reported, Hilton Hotels Corporation (NYSE: HLT) was hit with a downgrade.

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  • SunTrust analyst C. Patrick Scholes downgraded Hilton from Buy to Hold and maintained a $101 price target.

    The research note reminded investors that “Over the past two years, Hilton was SunTrust’s favorite hotel name, but after significant outperformance, Scholes sees gradual RevPAR growth deceleration in his forward channel checks.

    Revenue per available room, or RevPAR, is a performance metric used in the hotel industry. It is calculated by multiplying a hotel’s average daily room rate (ADR) by its occupancy rate. This is an important metric for analysts considering stocks in this sector.

    The analyst also says Hilton has one of the strongest net rooms growth percentages in the industry, growing 6.5% this year, but he believes they’re at their cyclical peak.

    “The good news is that next year’s unit growth percentage will be similar to this year’s however we attach a very low probability that that figure will be materially better than this year’s,” he said in a note.

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  • Scholes says Hilton should see EBITDA growth in 2020 but due to the RevPAR deceleration and peak unit growth percentage, he has a difficult time keeping the stock at a Buy rating.

    EBITDA, or earnings before interest, taxes, depreciation, and amortization, according to Investopedia, is a measure of a company’s overall financial performance and is used as an alternative to simple earnings or net income in some circumstances. EBITDA, however, can be misleading because it strips out the cost of capital investments like property, plant, and equipment.

    This metric also excludes expenses associated with debt by adding back interest expense and taxes to earnings. Nonetheless, it is a more precise measure of corporate performance since it is able to show earnings before the influence of accounting and financial deductions.

    Simply put, EBITDA is a measure of profitability.

    The stock was down and this downgrade could certainly have been a factor.

    HLT daily chart

    The news comes as the stock is facing what could be a significant top on the longer term chart using weekly data that is shown below.

    HLT weekly chart

    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.

    bear call spread

    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.

    Every day, we scan the markets looking for trades that carry low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.

    When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.

    Bear Call Spread in HLT

    For HLT, we could sell an August 16 $95 call for about $2.20 and buy an August 16 $97.50 call for about $1.20. This trade generates a credit of $1, 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 $100. The credit received when the trade is opened, $100 in this case, is also the maximum potential profit on the trade.

    The maximum risk on the trade is about $150. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($100).

    This trade offers a potential return of about 66% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if HLT is below $95 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 $150 for this trade in HLT.

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