This Stock Just fell For No Reason, and That’s a Reason to Trade
In the long run, fundamentals tend to drive the market price of a stock. A company that increases sales and earnings for an extended period of time will be rewarded with a high stock price. Apple is an example of that.
In a similar manner, a company that fails to deliver growth in sales and earnings will decline in value. An example of that type of business is General Electric.
While that is true in the long run, in the short run, it is often news that drives a stock price. We often see prices react to earnings announcements or product developments. The news explains the move in those cases.
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That’s why when we see a large move without news, that’s important to consider. An example of this is CenturyLink, Inc. (NYSE: CTL), a stock that recently fell more than 5% in one day with no real news.
Some News Isn’t Newsworthy
There was some news about the company. PR Newswire reported that, “for the fourth consecutive year, CenturyLink, has been named the Asia Pacific Hybrid IT Service Provider of the Year by Frost & Sullivan.
The award recognizes CenturyLink’s role in empowering Asia Pacific businesses to successfully manage different IT environments through its comprehensive portfolio of hybrid IT services that are bolstered by a secure, fiber-rich global network.”
The release included a great deal of flowery language, such as “As digital transformation continues to be a key organizational goal for Asia Pacificb usinesses, it is even more crucial to address challenges such as finding a suitable, cost-effective network hosting service that can seamlessly integrate the various technology platforms, applications and services a business uses.
CenturyLink is well positioned to support businesses in their digital transformation by offering them unparalleled control and agility over their cloud environments.”
As you can see, none of that is specific enough to address the stock’s price move. Yet, the price did move. Looking at a chart using weekly data, we see that the stock did hit resistance before the selloff.
At the current price, CTL yields more than 9%. That high yield is a sign of trouble. The chart pattern shows that traders who owned the stock for two years or more have collected a dividend but seen no real price appreciation.
In this case, technical analysts and that chart might explain the selloff. That can be as important as news since many traders do make decisions based on technical analysis. This selloff could be the warning that additional downside in the stock is now likely.
A Trading Strategy to Benefit from Potential Weakness
The prospects of a further short-term gains in CTL seem to be remote. But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for CTL
The bearish outlook for CTL, at least for the purposes of this trade, is a short-term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the September 21 $27 put can be bought for about $4.90 and the September 21 $22 put can be sold for about $0.60. This trade will cost about $4.30 to enter, or $430 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $430. This loss would be experienced if CTL is above $27 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in CTL, the maximum gain is $0.70 ($27 – $22 = $5; $5 – $4.30 = $0.70). This represents $70 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $430 to open this trade.
That is a potential gain of about 16% of the amount risked in the trade. This trade delivers the maximum gain if CTL closes below $22 on September 21 when the options expire.
Put 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 $430 for this trade in CTL.