This Trade Could Benefit from the Temporary Shortage of Marijuana
Something seemingly predictable happened in the marijuana market. When cannabis was legalized in Canada, consumer demand was so high that companies in the industry struggled to keep up.
According to Market Watch, more than a month after recreational marijuana was legalized in Canada, “provinces say stores are still having trouble procuring enough pot from producers that have built large valuations on promises of selling tons of the drug.
MarketWatch talked to officials and retailers in eight of Canada’s 10 provinces, and all said they are receiving only small portions of the product they have ordered.
One of the provinces, British Columbia, the third largest province in the country, said supply issues aren’t expected to be resolved for six to 18 months, based on discussions with licensed pot producers.
The other provinces did not give many reasons for investors to be optimistic, largely saying the shortages would hamper operations for weeks and likely much longer amid what one private retailer called “a national shortage” of cannabis.”
Company Performance Reflects the Shortage
Companies in the sector reported results that showed the scale of the shortage.
Five of the country’s largest companies reported earnings that indicated they shipped less than 1% of the expected C$1 billion ($755.5 million) in recreational sales anticipated by Statistics Canada for 2018 in the first two weeks of legalization.
That makes it unlikely the sales target will be reached this year and major companies are blaming the government run wholesale buyers for the shortfall.
For example, Canopy Chief Executive Bruce Linton said the company’s shortfall was due to the fact that provinces bought only enough cannabis to test their supply infrastructure and did not ramp up sales as expected.
Aurora CEO Terry Booth said Ontario and British Columbia failed in rolling out their retail operations, and the only provinces that did well were Alberta and “perhaps” Saskatchewan.
The CEO added that Aurora had met all of its supply agreements with every province with which it is doing business and claimed it supplied 30% of Ontario’s pot. Ontario is most populated province in the country.
While this is likely to be a short term problem for the industry, traders sold on the earnings report and potentially set up bargains for long term investors. The chart of Aurora (NYSE: ACB) shows the short-term weakness in the stock.
The longer term chart shows that the stock is near an important support level and could be suitable for long term investors.
But, in the short term, there could be an opportunity to benefit from the recent bad news as traders wait for news that the provinces have corrected their supply chain problems.
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 ACB
For ACB, we could sell a January 18 $6 call for about $0.65 and buy a January 18 $8 call for about $0.23. This trade generates a credit of $0.42, 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 $42. The credit received when the trade is opened, $42 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $158. The risk can be found by subtracting the difference in the strike prices ($200 or $2.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($42).
This trade offers a potential return of about 27% of the amount risked for a short term trade. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if ACB is below $6 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 $158 for this trade in ACB.
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.