May 2, 2015
The Safest Way I Know to Make
40% on a Stock Set to Plummet
By Jared Levy
A headline on Yahoo Finance Friday morning caught my eye: "Could This Be the Beginning of the End of the Social Media Mania?"
The article was penned by Scott Fearon, the founder and president of Crown Capital Management hedge fund, and it started like this:
"I'm kicking myself for not following my instincts and shorting Yelp (NYSE: YELP) before it announced utterly rancid earnings on Thursday morning."
Shares of YELP plummeted 23% on Thursday after the company missed earnings estimates and showed a slowdown in user growth. For the first quarter, Yelp reported a loss of $0.02 per share, double what analysts had expected. Revenue also fell short. And while the number of monthly active users during the first quarter was up 8% year over year to 143 million, this paled in comparison to the 30% growth seen in the first quarter of 2014.
The final nail in the coffin was a lower-than-anticipated revenue forecast for the current quarter. Inventors quickly abandoned ship, and traders who did short the shares prior to the announcement made a nice sum for a day's work.
Despite Fearon's concerns (to put it mildly) about Yelp and other social media companies' business models and their "stupidly large valuations," he said he avoided shorting them because the risk of betting against companies "in the midst of a secular mania" is too high.
He is right. Shorting stocks is incredibly risky. Shorting volatile stocks even more so. And shorting stocks Wall Street loves -- even when that affection if far from justified -- is riskiest of all.
If a stock you bought falls to zero, the most you can lose is what you paid for the shares. But when you sell a stock short, your losses can be infinite, as there is technically no limit to how high a stock can go.
But that doesn't mean you should avoid playing stocks on the downside either. As Fearon reminds us, "Stocks eat like birds but crap like bears." In other words, you can often make a hell of a lot more money in a much shorter time period from a falling stock than from a rising one.
Like Fearon, I saw the writing on the wall with Yelp. While I also wasn't willing to take on the risk of shorting the stock, I wasn't willing to sit on the sidelines either.
So I bought put options, and I turned the post-earnings massacre into a 40% profit without ever risking more than $395.
Many people mistakenly lump options in with risky strategies like shorting, but that is way off base. As I said, the risk of shorting a stock is theoretically unlimited, while with buying options you can never lose more than you put in -- just like buying a stock. Put options are the safest way I know of to make money on a falling stock.
And you can make a lot of money.
At the beginning of April, I told subscribers to my Profit Amplifier service that Yelp seemed especially vulnerable to a sell-off when it announced earnings at the end of the month.
This was in large part due to the weakness following its previous report. While fourth-quarter sales were slightly better than expected, management's full-year earnings guidance was 16% lower than consensus estimates.
While stumbling on lower guidance can be expected with most companies, it can be a problem when your company is trading at nearly 340 times forward earnings. The day after Yelp's fourth-quarter report, shares fell 22%.
My analysis predicted we would again see a lackluster earnings report in late April, and using the previous earnings gap, I ran the Fibonacci levels to come up with a realistic target. Technical analysis has shown that after a significant up or down move, a stock's new support and resistance levels will often fall near these lines.
In this case, I measured the difference from YELP's previous post-earnings low to its high at the time, and my target of $39.75 fell at the 61.8% retracement level, 13% below where it was trading. Using put options, I planned to leverage that move into 40% profits.
Specifically, I recommended traders buy the YELP Aug 50 Puts, which were trading at $7.30. Each option contract controls 100 shares, so we paid $730 per contract.
That was the absolute most we could lose, but I added another measure of safety in the form of a stop-loss on the option at $3.35. So really the most that was ever at risk was $395 per contract ($730 cost minus $335 stop).
I also gave the trade some extra time to work out by purchasing puts that expired in August. That way, if earnings weren't as bad as I predicted they would be, there was time for the other negative catalysts -- its poor chart, softening financial strength and a potentially devastating blow to its reputation from an upcoming grassroots documentary -- to pull shares down to my target.
As it turned out, I didn't need the extra time, as shares plummeted from a close of $51.28 on Wednesday to a low of $38.75, blowing through my downside target.
When I recommended the put option, I had traders place a good 'til canceled (GTC) limit order at $10.25 (strike price of $50 minus $39.75 target price) to get us out of the trade automatically. When this was triggered on Thursday, we booked a profit of 40.4% in 29 days, for an annualized return of 508.6%. And remember, we never risked more than $395.
Since launching Profit Amplifier in late February, I've also made a 33.9% return in 56 days on an 11% drop in Keurig Green Mountain (NASDAQ: GMCR) and a 90.5% return in 15 days on an 11% move up in Valero Energy (NYSE: VLO).
We currently have six other trades in our portfolio, and I recommend a new one each week.
Earnings season is one of the best times to use options to benefit from big moves in stocks -- whether up or down. With the Q1 reporting period in full swing, I expect some more great setups in the weeks to come.
If you're interested in learning more about how I pick my options trades or in trading alongside me, follow this link.
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