When a Rally Fails, This Could Be the Best Trade
Stocks can move from boom to bust based on fundamentals. But sometimes the moves come from investors’ perceptions of fundamentals. For example, an investor might think that there are reasons to believe the company is the next Microsoft or Amazon or some other amazing growth story.
That leads to a boom in the stock and is often associated with booming fundamentals. Then, traders in the stock seem to begin to realize the price is well ahead of the fundamentals, even if the company continues to deliver strong results.
One example of what can happen with that realization could be playing out in Coupa Software Incorporated (Nasdaq: COUP).
A Boom in Sales Shows the Potential of This Company
Coupa Software provides a unified, cloud-based spend management platform that connects organizations with suppliers globally. The company offers spend management cloud applications, which are pre-integrated. The platform offers consumerized financial applications.
Its spend management suite includes procurement, invoicing, expenses, sourcing, inventory, contract lifecycle management, budgeting, analytics, open business network, supplier information management and storefront.
The platform offers features, such as procure-to-pay solution; online invoice management, and inventory management and tracking software system. Its solutions for business needs include financial compliance and mobile productivity.
The company’s solutions for enterprise resource planning (ERP) include Oracle and NetSuite. The Company offers solutions for industries, including financial, healthcare, oil and gas, retail, technology, and food and beverage.
Customers include United Airlines, Finnair, ISS Group, Golden State Warriors, Coors Distribution Company, Darden Restaurants, Cvent, AAA Club Alliance, Lime Bike, Axiata Group, Genesis Energy, SkillSoft, Consolis, KPMG Canada, POWDR, Informa Exhibitions and Santos Limited, among others.
Sales have grown from $50 million in 2015 to almost $200 million in the last twelve months. The company has yet to report a profit.
Until recently, the stock price soared.
The Latest Report Seems to Raise Concerns
In the most recent quarter, according to ZACKS,
“COUP reported third-quarter fiscal 2019 non-GAAP earnings of 8 cents per share, in contrast with the Zacks Consensus Estimate of a loss of 3 cents. Notably, the company reported a loss of 5 cents in the year-ago quarter.
Revenues surged 42% from the year-ago quarter to $67.5 million, driven by growth of 42% in subscription services, which totaled $60.6 million. However, professional services & other revenues increased 51.7% to $6.9 million.”
Further, the figure surpassed the Zacks Consensus Estimate of $63 million.
The top line was primarily driven by expanding customer base. Further, rising adoption of Coupa’s platform is driving subscription services revenues and gross margin.
As of Oct 31, 2018, Coupa had cash and cash equivalents of $227.6 million, down from $282.1 million in the previous quarter. But cash flow does appear strong. Cash flow from operations came in at $27.9 million during the nine months ended Oct 31. Free cash flow was $2.6 million during the third quarter.
For fourth-quarter fiscal 2019, revenues are anticipated between $67.8 and $68.3 million. The Zacks Consensus Estimate for revenues is currently pegged at $63.9 million.
Moreover, non-GAAP income from operations is anticipated to be at a break-even. Non-GAAP net income is also anticipated to be at a break-even.
For fiscal 2019, total revenues are now expected between $253 million and $253.5 million. The Zacks Consensus Estimate for revenues is currently pegged at $244.6 million.
Non-GAAP income from operations is now anticipated between $9.5 million and $10.5 million. Non-GAAP net income is expected in the range of 11-13 cents per share.
But, the stock has been pulling back.
With a triple digit price to earnings (P/E) ratio, there may be little upside even if the company exceeds expectations.
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.
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.
A Bear Call Spread in COUP
For COUP, we could sell a December 21 $60 call for about $2.90 and buy a December 21 $65 call for about $1.00. This trade generates a credit of $1.90, 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 $190. The credit received when the trade is opened, $190 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $310. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($190).
This trade offers a potential return of about 61% of the amount risked for a holding period that is relatively short. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if COUP is below $60 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 $310for this trade in COUP.
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.