Trading a Dead Cat Bounce
Even casual investors are often familiar with the names of some chart patterns. They may have heard of a head and shoulders top or a capitulation bottom. These patterns have memorable names and they are not the only tools technical analysts have provided colorful names for.
Among the most colorful names is the dead cat bounce. The logic, if that is the right word, behind this trade is that if you drop a dead cat off of the top of a skyscraper, it will hit the ground and bounce before hitting the ground again.
In the stock market, the dead cat bounce is a pattern seen when a stock suffers a steep decline, bounces slightly higher and then resumes its decline. The decline is often due to a significant deterioration of fundamentals.
Traders can see a potential dead cat bounce playing out in the market right now.
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Lending Tree Drops Hard
Recently, LendingTree (Nasdaq: TREE) has been in a freefall after the company reported weaker than expected earnings and the Federal reserve raised interest rates.
The earnings miss occurred in April. TREE reported earnings per share of $1.10. The average estimate of five analysts surveyed by Zacks Investment Research was for earnings of $1.17 per share.
The mortgage lending service provider posted revenue of $181 million in the period, surpassing Street forecasts. Four analysts surveyed by Zacks expected $173.6 million.
For the current quarter ending in July, Tree.com said it expects revenue in the range of $193 million to $200 million. The company expects full-year revenue in the range of $770 million to $790 million.
But, traders are concerned that the company’s revenue projections could be optimistic in the face of rising interest rates. Mortgage rates are near five year highs.
Source: Federal Reserve
Higher rates could lead to lower activity in the mortgage market. This could be especially true for refinancing activity since home owners will generally only refinance if rates are lower. It is reasonable to assume refinancing activity is slowing and could become just a small part of the mortgage market.
That would leave mortgage lenders dependent on the sales of homes for business and it’s possible that higher prices in the real estate market could slow sales.
Source: Federal Reserve
Higher interest rates combined with higher home prices squeeze many consumers out of the real estate market and that could reduce demand for mortgages. Another threat to the business is the risk of rising mortgage defaults.
Source: Federal Reserve
There is no sign of that yet but the downward trend in defaults is likely to reverse at some point, most likely when the economy weakens, and unemployment rises.
Combined, these trends point to the probability that the recent trend in TREE is a dead cat bounce.
A Trading Strategy To Benefit From Weakness
To benefit from the expected weakness in the stock, an investor could buy put options. 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 for the short term, 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 TREE
For TREE, 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 an August 17 $290 call for about $3.20 and buy an August 17 $300 call for about $1.20. This trade generates a credit of $2.00, 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 $200. The credit received when the trade is opened, $200 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $800. The risk is found by subtracting the difference in the strike prices ($1,000 or $10.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($200).
This trade offers a potential return of about 20% of the amount risked for a holding period that is about three weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if TREE is below $290 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 $800 for this trade in TREE.
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.