Traders Learned Bad News the Day After Christmas
Traders who peeked at the news on the holiday knew something would happen at the open. As Fortune reported, “Wall Street Just Gave Apple a Huge Lump of Coal for Christmas.”
Analysts lowered their projections for the iPhone X shipment for the first quarter of next year. Reports noted there were indications of lackluster demand at the end of the holiday shopping season.
Sinolink Securities Co. analyst Zhang Bin said in a report Monday that handset shipments in the period may be as low as 35 million, or 10 million, less than he previously estimated.
“After the first wave of demand has been fulfilled, the market now worries that the high price of the iPhone X may weaken demand in the first quarter,” Zhang wrote.
This view was echoed in a report form JL Warren Capital LLC which said shipments will drop to 25 million units in the first quarter of 2018 from 30 million units in the fourth quarter, citing reduced orders at some Apple suppliers.
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The drop reflects “weak demand because of the iPhone X’s high price point and a lack of interesting innovations,” the New York-based research firm said in a note to clients Friday.
As traders would expect after news like this, the price of Apple Inc. (Nasdaq: AAPL) fell on the news. Shares of the company’s suppliers were also down on the news. Among the hardest hit suppliers was Micron Technology, Inc. (Nasdaq: MU).
Micron Could See Profit Taking
Investors in Micron have long believed the stock was an unrecognized value. But, that could have changed this year when the stock price climbed by more than 400%.
Investors who have held the stock for years might be willing to sell at the first sign of weakness given the stock’s long term performance which is shown in the next chart. The monthly view shows investors saw few gains from 2002 until a rally began in 2012.
The stock’s most recent rally pushed the stock to the highest levels seen since 2001. Long term investors may be more willing to sell after experiencing the sharp decline in 2015 that wiped out significant profits. This is the investor psychology that leads to resistance levels on charts.
Resistance is a pattern identified by technical analysts. It is a price level that is expected to be associated with an increase in selling pressure. The increase could be caused by investors’ concerns that the stock is unlikely to rally further.
As an example, MU rose to about $36 in 2014 before subsequently falling by more than 70%. Many investors who bought the 2014 would be experiencing what behavioral economist Hersh Shefrin calls “get evenitis.”
Shefrin noted that investors tend to be predisposed to this behavior. He found that when a stock declines, investors tend to develop the opinion that they should sell when they see a rally that pushes the price back to their get even level.
With MU, long suffering share holders are likely to be especially vulnerable to concerns of a renewed drop. That could explain why the stock was among the hardest hit of Apple’s suppliers.
A Trading Strategy for Get Evenitis
Now, MU faces resistance resulting from the stock’s previous high, its perilous decline and the concerns that Apple’s fortunes could weigh on sales and profits for at least the next few quarters. This means many investors may be more willing to sell the stock than hold to see what happens.
This makes sense given Micron’s history of struggling to deliver significant long term gains to its share holders. This almost certainly will prevent a significant rally in the stock price on the short run.
The expected short term down trend in the stock creates a trading opportunity.
To benefit from weakness, an investor could buy put options. But, as the chart shows, MU has been in a downtrend over the past few days and that has resulted in increased volatility. The higher volatility increased options premiums even more. This is normal behavior when a sell off occurs.
But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility. In this case, with a bearish outlook, a call option should be sold.
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 is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in MU
For MU, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell a January 5 $44 call for about $0.50 and buy a January 5 $46 call for about $0.17. This trade generates a credit of $0.33, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $33. The credit received when the trade is opened, $33 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $167. The risk is found by subtracting the difference in the strike prices ($200 or $2.00 time 100 since each contract covers 100 shares) and then subtracting the premium received ($33).
This trade offers a return of about 19.7% for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if MU is below $44 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 $167 for this trade in MU.
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