This Index Change Could Boost a Former High-Flyer
When a stock is added to an index, there are a new group of buyers who are forced to take action. This is because exchange traded funds (ETFs), mutual funds and institutional managers often track indexes. These managers are forced to buy the stock, and they are also forced to hold it.
This creates new demand for the stock as millions of dollars moves into the stock and becomes long term investments in the fund. In effect, it removes part of the stock available for day to day trading and can limit the volatility of the stock in the future. This is especially true for smaller cap stocks.
Based on these realities, recent news creates a trading opportunity in a small cap stock. As Bloomberg reported,
“With national bookseller Barnes & Noble Inc. set to go private this month, the index makers at S&P Global had a spot to fill in their SmallCap 600 Index.
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The lucky entrant? National Beverage Corp., the maker of LaCroix flavored sparkling water. The company (Nasdaq: FIZZ) jumped as much as 9.2% [recently], the most since November 2017, on the planned S&P index inclusion, set to become effective before the open Aug. 7.
Membership in the small-cap index may bring in new investors after a rough stretch for the $2.1 billion soft-drink company, which has lost more than half of its market value over the past 12 months amid increasing competition in the seltzer aisle and declining revenue.
Shares of National Beverage, whose other brands include Shasta and Faygo, are still up more than 100% from where they were in late 2014. The long- term chart using weekly data shows the ups and downs of the stock over the past few years.
The stock is now at an important technical support level and has guaranteed buying pressure in place from index funds and then solid support from those funds who will be long term holders limits, but does not eliminate, the risks of the stock. This creates a low risk entry level for long term investors and a short term opportunity for more aggressive traders.
A Trade for Short Term Bulls
As with the ownership of any stock, buying FIZZ 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.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for FIZZ
Every day, we scan the markets looking for trades with 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.
For FIZZ, the September 20 options allow a trader to gain exposure to the stock.
A September 20 $50 call option can be bought for about $2.30 and the September 20 $55 call could be sold for about $0.97. This trade would cost $1.33 to open, or $133 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 $133.
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 FIZZ the maximum gain is $3.67 ($55 – $50= $5; $5 – $1.33 = $3.67). This represents $367 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $133 to open this trade.
That is a potential gain of about 175% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.