This Is Why the List of Losers Provides Trading Opportunities
Some traders wish they could trade more but have a difficult time coming up with trade ideas. One tip they should consider is using the list of stocks showing the largest declines each day.
The largest losers is a list of some of the most volatile stocks in the market that day. Volatility is important for traders because it can create trading opportunities. This is especially true for options traders. To explain the concept, consider The Cheesecake Factory Incorporated (Nasdaq: CAKE).
The day after reporting earnings, the stock fell sharply.
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A Disappointing Report
CAKE reported earnings of $0.65 per share, missing the Zacks Consensus Estimate of $0.81 per share. Zacks noted, “This compares to earnings of $0.78 per share a year ago. These figures are adjusted for non-recurring items.
This quarterly report represents an earnings surprise of -19.75%. A quarter ago, it was expected that this restaurant chain would post earnings of $0.68 per share when it actually produced earnings of $0.56, delivering a surprise of -17.65%.
Over the last four quarters, the company has not been able to surpass consensus EPS estimates.”
Given the news, it’s not surprising to see the stock drop.
Traders without a position need to consider the likelihood of a rebound.
The Long Term Chart Provides a Strategy
The longer term chart of the stock is shown next. This chart uses weekly data and shows the depth of the earnings related decline in context.
The decline puts the stock back to levels seen in March. That means traders who bought the stock in the past four months now face a loss.
Additionally, the top in 2017 looks like it may have trapped some buyers into a loss. Many investors probably held on through the decline and subsequent rally. They may have been planning to get out when they could sell at the break even level.
This problem, called “breakeven-itis,” in behavioral economics can be significant in stocks. Investors often hate to take a loss so they tell themselves it’s not a loss until they sell. After a rally delivers the chance to sell without a loss, many will, relieved that they broke even on the trade.
Share holders hoping to break even might now sell, adding to the pressure on the stock.
All of this points to additional weakness in the stock since buyers are unlikely to appear in the short term. Traders can use various options strategies to benefit from expected weakness in a stock including one that offers potential short term income, making it especially appealing when volatility spikes.
A Trading Strategy To Benefit From Weakness
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook for the short term, a call option should be sold.
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 is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in CAKE
For CAKE, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell an August 17 $50 call for about $0.70 and buy an August 17 $55 call for about $0.10. This trade generates a credit of $0.60, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $60. The credit received when the trade is opened, $60 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $440. The risk is 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 ($60).
This trade offers a potential return of about 14% of the amount risked for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if CAKE is below $50 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 $440 for this trade in CAKE.
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.