This Long Time Laggard Could Be Set to Soar
Stocks are often thought of as long term investments because some investors want to own a stock for years. This is a strategy that can be used if you have many years to wait for gains to develop. But, not everyone does.
The long term approach can be especially appealing to value investors who look for great companies that are suffering through difficult times. One company that fits that description is Micron technology, Inc. (Nasdaq: MU).
A long term chart of Micron is shown below. The stock recently broke out to its highest level in 15 years. The pattern on the chart is now bullish.
Further Gains Are Likely for MU, In the Long Run
After a breakout, traders are often left with the question of what’s next. In the case of Micron, the answer depends on the time horizon.
Micron’s recent rally was driven by a strong earnings report. Near the end of September, the company announced better than expected earnings for the most recent quarter.
In the fourth quarter of the company’s fiscal year, Micron reported revenue of $6.1 billion. That was nearly double the revenue of $3.2 billion reported for the same quarter a year ago. Earnings per share (EPS) came in at $2.02.
Both revenue and EPS exceeded analysts’ expectations. Analysts had been looking for Micron to report revenue of about $6.0 billion and EPS of $1.84 for the quarter. The company beat analysts’ revenue estimate by 3.0% and the earnings estimate by 9.8%.
Management also provided a bullish outlook for the current quarter.
Micron expects revenue between $6.1 billion and $6.5 billion in the first quarter of the company’s 2018 fiscal year. Analyst estimates had been clustered near the low end of the guidance. Management expects EPS to be between $2.09 and $2.23, which is well above analysts’ consensus estimate of $1.85 before the earnings call occurred.
Fundamental conditions look promising for the company. Micron noted that the average selling price of one of its most important products, DRAM or dynamic random access memory chips, rose 8.0% in the last quarter. Management sees a supply shortfall for DRAM continuing until the end of 2017.
Of the 31 analysts covering Micron stock, 29 recommend a “buy,” and two recommend a “hold.” The average 12-month price target for Micron is $49 with a median target of $48.50 and is trading at a discount of 22.8% to median target estimates.
These factors point to more gains in the long run. But, in the short run, the stock could fall into a trading range as it consolidates recent gains. The next chart shows how overbought the stock has become.
Overbought is a term that technical analysts use to describe a stock that has gone up “too far, too fast.” The stochastics, a popular momentum indicator is shown in the center of the chart. This indicator has been overbought almost continuously since the beginning of August.
Stochastics is warning of a pullback, or at least a stall in the up trend. The rate of change at the bottom of the chart shows how unsustainable the pace of gains has been. In the past month, the one month percentage change in the stock has topped 25%.
On an annualized basis, MU is moving up at a rate of 122% a year, a pace that is likely to slow. As the rate of change slows, the stock’s advance should stall in the short term. In the long run, more gains are possible but in the short run, a large gain seems unlikely.
A Short Term Strategy For MU
After the rapid gains, the stock is likely to fall into a relatively narrow trading range. This could be frustrating to long term investors who are anxious to see additional gains. It could also frustrate short term traders who bought because momentum was high.
In either case, those investors could sell. Value investors seeking to build a long position in the stock could be the buyers. In this case, buying and selling could be roughly in balance and the result would be a trading range for the stock.
One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in Micron
For MU, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day. These are weekly options that expire on Friday, October 20.
The difference in the exercise prices of the calls or puts is equal to $1.00. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $100 less the premium received when the trade was opened.
Selling the options will generate $0.59 in income ($0.44 from the call and $0.15 from the put). Buying the options will cost $0.37 ($0.28 for the call and $0.09 for the put). This means opening the trade will result in a credit of $0.22, or $22 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($1.00) minus the premium received ($0.22). This is equal to $0.78, or $78 since each contract covers 100 shares. Most brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $78 in capital.
The potential reward on the trade ($22) is 28% of the amount risked, a high potential return on investment. The trade will be open for about two weeks. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider