This Stock’s Weakness Could Deliver High Income to Traders
Options allow traders to create what some may think of as unique strategic trading opportunities. For example, income is a widely pursued investment strategy. It’s possible to use options for income. Among the popular strategies are covered calls and selling naked puts.
These strategies are popular and relatively simple. But, and the but is rather important for investors to consider, these two strategies exposure investors to the possibility of large losses. Other options strategies could be useful for investors who are concerned with risks.
Among those strategies is the bear call spread, a strategy that could be relatively straightforward to implement. One way to implement this strategy is to wait for bad news and then open a position. The bad news increases volatility and makes options selling strategies more attractive. The spread limits the risk.
Recent news offers an example. The Street reported,
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Shares of Smartsheet (SMAR) took a pounding [recently] after the cloud-based work platform reported a quarterly loss.
Smartsheet’s stock price plunged 8.7% … as the tech company reported a non-GAAP loss of 8 cents a share in the second quarter, or $9 million, compared with a loss of $8.1 million in the same period in 2018.
The decline in Smartsheet’s stock price came even as the company beat analysts’ expectations on earnings and revenue.
The tech firm’s loss of 8 cents a share was half of the 16 cents a share predicted by analysts surveyed by Zacks Investment Research.
Smartsheet also beat analysts’ estimates on revenue by 1.79%, with a 53% jump in revenue during the quarter to $64.6 million, according to Zacks.
The company also touted big increases in the number of customers signing up for its cloud-based work platform in the second quarter.
“We delivered another strong quarter by executing our strategy of providing high-value solutions for enterprises, expanding Smartsheet’s presence in new and existing customers, and driving international growth,” said Mark Mader, president and CEO of Smartsheet, in a press statement.
Even so, Smartsheet also reported negative net operating cash flow of $2.7 million in the quarter, up from $1.1 million the year before, while its GAAP operating loss rose to 32% of revenue in the second quarter, up from 31% a year before.
The selling could accelerate as investors become nervous after the stocks run up and decide to lock in profits rather than risk potential losses.
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 SMAR
For SMAR, we could sell an October 18 $40 call for about $3.50 and buy an October 18 $45 call for about $1.40. This trade generates a credit of $2.10, 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 $210. The credit received when the trade is opened, $210 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $290. 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 ($210).
This trade offers a potential return of about 72% 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 SMAR 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 $290 for this trade in SMAR.