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This IPO Might Not Have Worked as Expected

This IPO Might Not Have Worked as Expected

Many investors look at IPOs as an opportunity to get into an investment that should be soaring. That, however, is not always how IPOs work.

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  • Yahoo Finance recently reported on a hot IPO from earlier this year:

    Shares of Slack Technologies (NYSE: WORK) ended lower [recently], recovering some of the losses the stock suffered after the company reported its first earnings results as a public company [the previous day].

    WORK daily chart

    Despite topping analysts’ estimates on the top and bottom lines, Slack disappointed investors with a weaker-than-expected forecast for the third quarter.

    The company’s Q3 2020 guidance laid out expectations for a loss of between $0.08 and $0.09 a share — slightly below analysts’ expectations of $0.07.

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  • Among issues that impacted results cited by the company was outages that impacted users.

    In its earnings calls with investors, Slack CFO Allen Shim said revenue growth came in above the high end of guidance, despite an $8 million one-time revenue headwind from credits issued related to “service level disruption in the quarter.”

    On this, Citi analyst Walter Pritchard told investors he spoke with Shim and Jesse Hulsing, VP of Investor Relations, who told him that the financial impact of another “service-level disruption” was pretty low going forward.

    Citi has a $39 1-year price target on the stock.

    “We believe that these future valuation levels are justified based on Slack’s long-term growth profile (Y/Y revenue growth trending to high teens by FY2028) and operating margin and the current software industry valuation levels,” wrote Pritchard.

    Analysts at Credit Suisse, led by Brad Zelnick, believe a trailing twelve-month billings growth of +65% y/y suggests strong underlying growth. They kept their Neutral rating and lowered their price target to $35.

    “Several large wins at Office 365 customers makes us feel incrementally better about Slack’s ability to compete against Teams in the Office 365 customer base,” they wrote.

    Similarly, Morgan Stanley analysts led by Keith Weiss see upside in the stock, even if Slack is “a clear #2 share leader against the large market opportunity.” The firm believes that Slack can succeed against its main competitor, Microsoft (MSFT).

    “In our base case model there remains plenty of market opportunity for Slack to grow into a multi-billion revenue run-rate company, even with Microsoft garnering a dominant market share,” the analysts wrote.

    “Slack has positioned itself as the innovation leader in the communication and collaborative applications market, with a well underpenetrated opportunity as large as $30+ billion.”

    However, the stock has moved significantly lower since it began trading, indicating traders question its leadership position.

    WORK 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.

    A Bear Call Spread in WORK

    For WORK, we could sell an October 18 $26 call for about $2.40 and buy an October 18 $28 call for about $1.45. This trade generates a credit of $0.95, 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 $95. The credit received when the trade is opened, $95 in this case, is also the maximum potential profit on the trade.

    The maximum risk on the trade is about $105. The risk can be found by subtracting the difference in the strike prices ($200 or $2.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($95).

    This trade offers a potential return of about 85% 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 WORK is below $26 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 $105 for this trade in WORK.

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