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This Volatile Stock Could Provide a 81% Gain In Less Than a Month

This Volatile Stock Could Provide a 81% Gain In Less Than a Month

Volatility can create trading opportunities and recent news highlights one of those opportunities. Investor’s Business Daily recently reported,

Tencent Music stock rose Tuesday as coverage was initiated on the Tencent Holdings (TCEHY) spin-off that has grown to dominate China’s music entertainment market.

The company held its initial public offering on Dec. 12, pricing shares at 13. The IPO raised $1.1 billion. The stock’s performance has been mixed since then.

TME weekly chart

Tencent Music is the largest online music entertainment platform in China. It owns the top four music apps, with about 800 million monthly users. It also has the largest music content library in China with over 20 million tracks from more than 200 music labels.

“In Asia, music is for more than just listening,” Huang wrote in a report to clients.

Long Term Potential

She said more than 45% of Chinese music users share their singing, short videos and livestreaming of music performances and music-related articles with QQ and WeChat. Tencent Holdings owns QQ and WeChat, the leading messaging apps in China. It also owns a majority stake in Tencent Music.

Tencent Music competes primarily with NetEase (NTES) Music and Ali Music domestically and with Spotify (SPOT) in the international market. Ali Music is owned by China e-commerce giant Alibaba (BABA). Spotify owns an 8.6% stake in Tencent Music and is the largest global music streaming service.

Tencent Music has multiple moneymaking models, including subscriptions, advertising, music sales, virtual gifts and premium memberships.

Huang expects Tencent Music revenue will top $2.8 billion in 2018, jumping to $10.5 billion by 2022. For its third quarter, the company reported adjusted earnings of 10 cents per share, up 100% from the year-ago period. That was the seventh quarter in a row of triple-digit gains. Revenue rose 65% to $722.2 million.

“In the past three years, Tencent Music has been the most aggressive buyer of music copyright and will continue to invest heavily in content and R&D for the next two years,” Huang wrote.

Tencent Music formed in mid-2016 after Tencent Holdings bought a controlling stake in China Music Corp. and combined that with Tencent’s own streaming business. Tencent Holdings is one of the largest internet companies in China, dominating the market in messaging services and gaming apps.

The stock price failed to move on the release of the report.

TME daily chart

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.

bear call spread

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 TME

For TME, we could sell a March 15 $16 call for about $1.30 and buy a March 15 $18 call for about $0.40. This trade generates a credit of $0.90, 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 $90. The credit received when the trade is opened, $90 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $110. 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 ($90).

This trade offers a potential return of about 81% 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 TME is below $16 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 $110 for this trade in TME.

For more information on options click here for our free guide, The Ultimate Guide to Options Trading.