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This New Business Opportunity May Take Time For Profits

This New Business Opportunity May Take Time For Profits

Some companies see new opportunities and rush into the market. They may not realize immediate profits and that can create opportunities for short term traders to realize profits.

One example is in a recent news story. As The Street reported,

Shares of online real estate platform Zillow Group (Nasdaq: ZG) fell … after the company posted a narrower-than-expected second-quarter loss but provided lower guidance on third-quarter revenue, particularly from its home-flipping business.

Shares of Zillow were down [sharply] after the company reported a second-quarter adjusted loss of $28.3 million, or 14 cents a share, vs. adjusted earnings of $25.9 million, or 13 cents a share, a year earlier.

ZG daily chartAnalysts polled by FactSet had been expecting a loss of 16 cents a share. Revenue came in at $599.6 million, above the $590.6 million expected by analysts.

Of focus for investors, however, was Zillow’s $56.5 million loss before interest, taxes, depreciation and amortization (EBITDA) in its Homes segment, which includes Zillow Offers, an algo-driven home-flipping service where buyers and sellers can interact directly.

As well, the company warned that that its Premier Agent business, which lets agents pay to be connected with potential home buyers, will lose as much as $80 million in the third quarter before EBITDA.

Overall, the home-search company is projecting third-quarter adjusted EBITDA of between an $18 million loss and a $2 million gain. That compares to a consensus estimate of $17 million, based on the average forecast of analysts polled by Factset.

Analysts were quick to downgrade Zillow following the earnings announcement.

Susquehanna analyst Shyam Patil lowered his stock price target to $42 from $45, noting the company’s latest results reflect the challenges it faces in luring home buyers and sellers away from traditional real estate sales methodologies – and making money doing it.

Canaccord Genuity analyst Maria Ripps also reduced her price target to $62 from $65, though kept her buy rating on the stock, while KeyBanc Capital analyst Brad Erikson cut his target to $56 from $63, though kept his rating at overweight.

This announcement does seem to mark a significant change in the focus of the company and that could mean the stock might languish until management is able to prove itself in the new market. The stock chart is bearish, and that creates trading opportunities.

ZG 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 ZG

For ZG, we could sell a September 20 $40 call for about $1.99 and buy a September 20 $45 call for about $0.58. This trade generates a credit of $1.41, 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 $141. The credit received when the trade is opened, $141 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $359. The risk can be 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 ($141).

This trade offers a potential return of about 39% 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 ZG is below $40 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 $359 for this trade in ZG.