Trading a High Priced Stock With Relatively Low Dollar Risks
As stock market indexes, many stocks are trading at record high prices as well. Even if they are far from records, some stocks are relatively high priced as companies increasingly allow their stock to trade for more than $100 a share rather than splitting as they did in the past.
One such stock recently reported earnings. Business Wire reported,
Molina Healthcare, Inc. (NYSE: MOH) today reported net income for the third quarter of 2019 of $175 million, or $2.75 per diluted share, compared to net income of $197 million, or $2.90 per diluted share, in the third quarter of 2018. Financial results for the third quarter of 2019 are summarized below:
The stock was up on the news.
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Highlights of the earnings report includes:
- Premium revenue was $4.1 billion in the third quarter of 2019, a 5.8% decrease compared to the third quarter of 2018.
- Medical care ratio (MCR) was 86.3% in the third quarter of 2019 compared to 87.4% for the third quarter of 2018.
- General and administrative (G&A) expense ratio increased to 7.6% in the third quarter of 2019 compared to 6.6% for the third quarter of 2018.
- The third quarter results include a charge of $2 million, or a $0.03 net loss per diluted share, for the repayment of convertible notes.
- After-tax margin was 4.1% for the third quarter of 2019 compared to 4.2% in the third quarter of 2018.
- Cash and investments at the parent company amounted to $796 million as of September 30, 2019.
- Operating cash flows for the nine months ended September 30, 2019, were $398 million.
The company also raised full year 2019 earnings guidance to $11.30 – $11.55 from $11.20 – $11.50, which does not include any future prior-period reserve development.
The company also noted that after the end of the quarter, on October 10, the company entered into a definitive agreement to acquire certain assets of YourCare Health Plan, Inc.
Through this transaction, expected to close early next year, the company will serve approximately 46,000 Medicaid members in seven counties in Western New York.
“We are pleased with our performance this quarter as we sustained our margin profile, produced significant excess capital, and increased our full year 2019 guidance,” said Joe Zubretsky, president and CEO. “We have accomplished this in the backdrop of commencing our pivot to growth.”
The weekly chart shows a consolidation is developing in the stock.
A Trade for Short Term Bulls
As with the ownership of any stock, buying MOH could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for MOH
Every day, we scan the markets looking for trades with 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.
For MOH, the December 20 options allow a trader to gain exposure to the stock.
A December 20 $130 call option can be bought for about $5.10 and the December 20 $135 call could be sold for about $3.02. This trade would cost $2.08 to open, or $208 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $208.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in MOH the maximum gain is $2.92 ($135- $130= $5; $5 – $2.08= $2.92). This represents $292 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $208 to open this trade.
That is a potential gain of about 40% in MOH, based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.