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This Selloff Could Lead to an 85% Gain in the Next Month

This Selloff Could Lead to an 85% Gain in the Next Month

Sometimes, waiting for the news can be profitable. An example, as Bloomberg reported, is in a well-known stock. Roku Inc. (Nasdaq: ROKU) shares suffered their second double-digit percentage drop of the past three trading days on Friday, as concerns over competition once again pressured a stock that has quadrupled since December.

ROKU daily chart

Shares of the video-streaming platform company sank as much as 18% in midday trading, its biggest one-day percentage loss since November, dropping on volume that already eclipsed its daily average volume over the past three months.

The stock was trading at a six-week low, and on track for a weekly drop of more than 25%.

With the decline, Roku has lost about 35% of its value since a record close hit earlier this month. Even with the drop, however, shares remain up more than 300% from a December low as investors see the company as a major beneficiary to a shift toward streaming video.

Friday’s decline was sparked after Pivotal Research Group started coverage on Roku shares with a sell rating and Street-low price target of $60, a target that represents downside of more than 55% from the company’s Thursday close.

Analyst Jeffrey Wlodarczak wrote that shares were “dramatically overvalued” after the 2019 rally, and that he sees “dramatically more competition emerging.”

Pivotal’s comments spoke to an issue that also weighed on Roku on Wednesday, after Facebook Inc. debuted a new model of its Portal video device that will have access to some streaming services, and Comcast Corp. said its Xfinity Flex box would be included with Internet-only subscriptions.

Wlodarczak sees such developments as a harbinger of things to come. He anticipates “dramatically more competition,” including from “big boys” like Comcast, whose plan “will inevitably be copied by other distributors”, and “likely drive the cost of [over-the-top video-streaming] devices to zero.”

These rivals have “massive leverage,” he wrote, and are likely to make growth “much more difficult.”

This bearish view is a minority opinion. Pivotal is only the second firm to recommend selling Roku shares, according to data compiled by Bloomberg, compared with the stock’s nine buy ratings and the five firms with a neutral view on the stock.

As occurred following the week’s previous drop, Roku bulls defended the name as shares declined. Needham analyst Laura Martin called it “the gold-standard pure play” of video streaming, one that was “underscored by flawless (our word) execution” and a continually expanding total addressable market.

The firm reiterated its buy rating and $150 price target in a note to clients. “Even if Roku’s hardware sales went to zero TOMORROW,” the financial downside “would be minimal” as it accounts for just 5% of its gross profit, Martin wrote (emphasis in original).

Separately, Oppenheimer on Friday affirmed its outperform rating despite the “pending SVOD war,” referring to streaming video on demand. “Roku’s U.S. strategy play-book should allow fast international market share,” the firm wrote.

“Many new services are playing catch-up in a crowded market, with limited scaled platforms to add [subscribers].”

The firm raised its price target to $155 from $120, and was at least the second firm this week to boost its view on Roku’s international potential, following a similar move from Guggenheim on Wednesday.

Currently, analysts expect full-year revenue growth of about 48% for 2019, and 36% growth in 2020, according to data compiled by Bloomberg. According to a Bloomberg MODL forecast, Roku is expected to have about 36.2 million active accounts at the end of 2019.”

The longer term shows that for now, the path of least resistance for the stock could be down.

ROKU 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.

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 ROKU

For ROKU, we could sell an October 18 $105 call for about $10.30 and buy an October 18 $110 call for about $8. This trade generates a credit of $2.30, 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 $230. The credit received when the trade is opened, $230 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $270. 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 ($230).

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 ROKU is below $105 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 $270 for this trade in ROKU.