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This Stock Shows the Real Outlook for China

This Stock Shows the Real Outlook for China

Consumers drive the economy all around the world. In the U. S. consumer spending accounts for the majority of the GDP number and a similar situation is seen in other countries. In developing economies, a primary goal is often to grow a middle class which will drive consumption and growth.

China is an example of a country with a growing middle class. In fact, the country’s middle class will eventually dwarf the size of the U. S. middle class.

working populations

Source: Goldman Sachs

This potential market explains why U. S. companies are expanding in China. But, it is always possible to be too early in a trend.

Computer historians will remember, as an example, Lotus 1-2-3, a spreadsheet software that once dominated its market, or Peach Text, a word processing package that was also popular at one time. They know that both products, although well liked, gave way to Microsoft, a company which stumbled in its early days.

First Movers Have Potential, But Can Suffer Pitfalls

Computer software demonstrates that there are advantages to being in a market early, and there are risks. This demonstrates that a company with great long term potential could, at times, struggle in the short run. That appears to be the case with Yum China Holdings, Inc. (NYSE: YUMC).

YUMC is a fast food giant in China. Its operating brands include well known names like KFC, Pizza Hut and Taco Bell. YUMC also operates the Little Sheep concept specializing in Hot Pot cooking and East Dawning, a Chinese food quick service restaurant brand. All together, YUMC operates more than 7,500 restaurants in China.

The stock was spun off from its parent, Yum! Brands, Inc. (NYSE: YUM) in 2016. The stock has been struggling in recent months.

YUM weekly chart

The weekly chart shown above indicates a clear top pattern. The name of the pattern could be debated. It could be called a complex head and shoulders by some analysts. The peak forming the head is clear and the secondary reactions at the shoulders are less clear.

Rather than focusing on the name of the pattern, it can be useful to consider what the pattern depicts. The peak was part of an up trend. That ended an up trend that had been in place since the stock began trading.

The fact that an up trend began soon after the stock was spun off could mean that many investors enjoyed gains if they bought in the first year of trading. Now, their gains could be slipping away and that could lead to an accelerating sell off in the stock.

The pattern clearly favors additional down side, at least in the short term. In the long run, YUMC may have a positive experience delivering fast food favorites to an increasingly large audience.

A Trading Strategy to Benefit From Potential Weakness

The prospects of further short term gains in YUMC 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.

Bear Put Spread

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 YUMC

The bearish outlook for YUMC, 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 August 17 $35 put can be bought for about $2.00 and the August 17 $32.50 put can be sold for about $0.80. This trade will cost about $1.20 to enter, or $120 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 $120. This loss would be experienced if YUMC is above $35 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 YUMC, the maximum gain is $1.30 ($35 – $32.50 = $2.50; $2.50 – $1.20 = $1.30). This represents $130 per contract since each contract covers 100 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $120 to open this trade.

That is a potential gain of more than 108% of the amount risked in the trade. This trade delivers the maximum gain if YUMC closes below $32.50 on August 17 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 $120 for this trade in YUMC.

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