This Stock Might Be Left Behind Even if the Stock Market Rallies
After a steep decline in stocks like we have seen over the past few weeks, traders often expect a rally. The rally could take the form of a dull rebound in stocks and new bull market highs. Or, it could take the form of a short term move that retraces a small part of the decline.
In the case of the broad market, the nature of the price move can be difficult to discern as it unfolds. It is only hindsight when traders know with certainty whether the advance was a short term rally or a full fledged recovery.
However, in individual stocks, the difference can be somewhat easier to spot. If a company delivers bad news, the odds of a full recovery usually decrease.
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Bad News Could Doom This Stock
It seems like the prospects of a rapid recovery in Advanced Micro Devices (Nasdaq: AMD) are remote after the company’s latest earnings guidance.
Yahoo Finance reported on the company’s news: “Advanced Micro Devices reported better than expected third quarter earnings, but the company released weak guidance.
“For the fourth quarter of 2018, AMD expects revenue to be appropriately $1.45 billion, plus or minus $50 million, an increase of approximately 8 percent year-over-year,” the company said in a statement.
That $1.45 billion compares to $1.6 billion expected by analysts.
The chipmaker’s Q3 earnings came in at 13 cents per share, which was just a penny above the 12 cents per share that was expected by analysts polled by Bloomberg. Revenue was roughly in line with analyst estimates at $1.7 billion.
“We delivered our fifth straight quarter of year-over-year revenue and net income growth driven largely by the accelerated adoption of Ryzen, EPYC and datacenter graphics product,” AMD President and CEO Lisa Su said.
The stock suffered a double digit decline on the news.
The decline appears to be more than a pull back after the stock’s large run up. AMD shares gained almost 130% since the start of the year. But, the stock is now down more than 30% from its highs.
Another factor weighing on AMD is the fact that its sector, the chip stocks, are often looked at by analysts as a proxy for the overall health of the global economy. That’s because companies invest in technology when the economy is strong, and chips are at the center of technology.
With concerns that the global economy is weakening, traders may be selling chips to get ahead of the trend. That could explain why the Philadelphia Semiconductor Index, which includes AMD, is struggling and suffered its worst one day decline since 2014.
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.
A Bear Call Spread in AMD
For AMD, we could sell a November 16 $19 call for about $1.90 and buy a November 16 $22 call for about $0.74. This trade generates a credit of $1.16, 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 $116. The credit received when the trade is opened, $116 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $184. The risk can be found by subtracting the difference in the strike prices ($300 or $3.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($116).
This trade offers a potential return of about 63% of the amount risked for a holding period that is about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if AMD is below $19 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 $184 for this trade in AMD.
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.