Traders Can’t Decide Whether They Should Sell or Buy This Stock
Sometimes, the chart changes from bearish to bullish, or vice versa. These are times when it appears that a pattern can be identified to signal a reversal in the direction of the trend. But, then, news is released and the stock becomes volatile.
There will be times when the news whipsaws a stock. This was the pattern that played out in Teva Pharmaceutical Industries (NYSE: TEVA) this week.
News Whipsaws Traders
Teva is the world’s largest generic drug maker. The stock has been in a sharp down trend since August. But, a small bottoming pattern on the chart indicating the down trend could be reversing.
A bottoming pattern can form when prices move within a relatively narrow range for several weeks. The lack of large declines in price indicates the selling pressure has eased. When selling pressure decreases, we expect buying pressure to develop and the stock should rally.
In the chart above, the horizontal blue line shows an area that is expected to be resistance. A resistance level is one that is expected to bring selling pressure into the market. Selling pressure will push a stock price lower. Traders often mark resistance by looking for important trend line breaks.
In the case of TEVA, resistance formed near $17. This is a price point where the stock’s initial down trend slowed and buying developed. The stock declined and some of those buyers closed their positions with a loss. Others held on hoping for a rally.
The stock appeared to be recovering but then turned lower and the stock fell, in line with where resistance was expected.
The stock fell nearly 5% on Wednesday on reports that Teva was planning a restructuring involving large layoffs in Israel, where the company is headquartered and has significant operations. The news led to calls for a half-day general strike to be held in protest.
Initial reports indicated the company would be closing its research and development center in the coastal city of Netanya, selling its logistics center in Shoham and cutting 3,300 jobs out of 6,430 nation-wide.
Political Leaders Join the Fray
Israeli Finance Minister Moshe Kahlon said only that he was following the situation closely. Avi Nissenkorn, chief of the Histadrut labour federation, declared a half-day general strike for Sunday, the beginning of the Israeli work week.
“The entire economy – from the (Ben Gurion) airport to the banks to the seaports to the municipalities to the government service to the health clinics – will stand until noon on Sunday in solidarity with Teva’s employees,” Nissenkorn told reporters.
He predicted mass layoffs under the Teva restructuring plan, which he described as “ruinous” for a company that was long a symbol of Israeli enterprise.
One of the plants earmarked for sale, Calcalist said, is the Teva Tech factory in Israel’s southern Negev desert. It produces raw materials for the pharmaceutical industry and employs 870 workers, according to Teva’s website.
“This is a young plant … and hundreds of millions of shekels of Israeli government money were invested here,” Meir Babayoff, chairman of the Negev region in the Histadrut, told Israel Radio.
He vowed to stop any layoffs and called on Israel’s government “to wake up”.
Officials with the company confirmed they would be discussing restructuring at a news conference the next day, leaving investors uncertain about what would happen.
The Plan Could Spark a Rally
There is a general agreement that Teva needs to restructure. The company took on nearly $35 billion in debt to acquire Allergan’s Actavis generic drug business for $40.5 billion. The company has been making changes since Kare Schultz joined as its new chief executive on Nov. 1.
On Thursday, in Israel, Teva did announce plans to reduce its workforce by 25% and suspend its dividend on ordinary shares in a much-anticipated overhaul to help pay back its massive debt. These measures will result in the reduction of 14,000 positions globally, with the majority of the cuts expected in 2018.
The two-year restructuring plan is intended to reduce Teva’s total cost base by $3 billion by the end of 2019, out of an estimated cost base for 2017 of $16.1 billion.
In premarket trading, the stock rallied nearly 5% almost completely reversing the previous loss. With the sell off eliminating weak hands, the stock appears likely to resume its up trend.
From the perspective of an options trader, there is quite a bit of good news in a large price move. The stock has become more volatile. This is generally true whether the stock has moved up or down on the big move.
Higher volatility is generally associated with higher options prices. This is because options prices reflect a number of factors. The price of a call or put option is affected by the price of the underlying stock, the current level of interest rates, the time left to expiration and the volatility of the underlying stock among other factors.
Increased volatility, when it leads to increased options prices, sets up a number of potential trading opportunities for options traders. That indicates that after a large price move, a trader doesn’t need to be concerned with whether or not the price move will be reversed.
Instead of accepting a position that depends on a directional move and can carry a great deal of risk, an options trader can establish a position with a high likelihood of success and a defined level of risk.
A Strategy to Trade Teva Pharmaceuticals
TEVA is likely to remain in a relatively narrow trading range while investors wait for news on how the restructuring is affecting the company’s bottom line. This indicates a significant move in the stock price is now unlikely after the recent bout of volatility.
When a stock is expected to remain in a narrow range for some time, it is possible to generate income from the stock. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread could be used. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which recently saw increased volatility and is likely to remain in a narrow range.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
For Teva, a bull put spread could be opened with the December 29 put options. This trade can be opened by selling the December 29 $14.50 put option for about $0.30 and buying the December 29 $12 put for about $0.06.
This trade would result in a credit of $0.24, or $24 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $2.00 ($14.50 – $12.50). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $226 ($250 – $24).
The potential gain is about 10.6% of the amount of capital risked. This trade will be open for about two weeks and the annualized rate of return provides a significant gain.
The bull put spread is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy could also simplify tax reporting for investors.
These are the type of strategies that are explained and used in Trading Tips Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.