Hedge a Blue-Chip Correction With This Trade
The bull market may not be over quite yet, but there are strong signals that an extended pullback is imminent as volatility and geopolitical concerns mount.
One way to play an upcoming correction is to find a large-cap, low-volatility stock that’s risen along with the overall market. When the market reverses down, that stock should follow suite. And when it does, using the strategy I’ll discus today could make outsized gains that will help offset any losses.
Intel (NASDAQ: INTC) is a good representative of the long-term bull market. This blue-chip stock has a market cap close to $170 billion and has profited from the revival in the tech sector. The chipmaker is globally known for its PC hardware and has outperformed so far in 2014, up 32% year to date compared with 6% for the S&P 500. But the good times may be ending.
The explosive popularity of smartphones and tablets has led to a global slump in PC sales. IDC said it expects worldwide PC shipments to fall 6% this year, following last year’s drop of 10%, and it predicts continuing difficulty through 2018.
Intel’s trailing P/E of 17 may look relatively cheap when compared with a sector P/E of about 23, but the stock is more of a value trap than a value buy right now. With a forward P/E of 15 based on 2015 earnings per share estimates (EPS) and long-term EPS growth expected to average less than 9% a year, INTC has a PEG ratio of 1.7 (1 is considered fair value).
Following a strong move from February through mid-July, INTC has been hovering in the $32 to $35 area.
Without some sort of news catalyst, shares are unlikely to move much in the near term. The company is scheduled to report third-quarter earnings on Oct. 14, but I doubt it will deliver a surprise that will have a significant impact on the stock’s price.
However, as we near the end of the year, institutional investors may begin dumping INTC and other semiconductor stocks, booking profits that will help with end-of-year window dressing. Additionally, an upcoming market correction could cause shares to break to the downside.
Because I expect Intel to hold steady in the short term and head lower down the road, the strategy I want to employ today is a long put calendar spread.
We set up this trade by selling a put option with a near-term expiration date and buying a put with the same strike price at a later expiration date. While we’re exposed to some downside risk in the event the short put is exercised and we are obligated to buy the stock at a lower price, it’s relatively short lived.
Recommended Trade Setup:
— Sell one INTC Nov 33 Put
— Buy one INTC Dec 33 Put
— Enter trade at a net debit of $0.50 or better ($50 per contract)
Selling the short-term put allows us to negate much of the cost of buying the longer-term put. In fact, you can typically cut the cost of buying a put option outright by half or more.
Because of the different expiration dates, there are two breakeven points.
The first leg of the trade expires in the third week in November. If INTC drops below $33 by Nov. 22, we will be obligated to buy 100 shares at $33 a share. As long as the stock stays above $33, our short put will expire worthless.
For the second leg of this trade, the long put, our breakeven point is $32.50 — the $33 strike price minus our net debit of $0.50. If the stock drops after our first leg expires but before expiration on Dec. 20, then we will profit from any gains made beyond $32.50. Here the profit potential is technically unlimited, while our maximum loss is limited to the cost paid to initiate the position.
Let’s assume that INTC stays near its current price through November expiration and our short put expires. If the stock then falls to $30 by expiration in December, our long put will be in the money by $3 for a $300 per-contract profit. Subtracting our $50 debit, we will net $250 for a 500% return on our investment.
If the stock falls faster than anticipated, our downside is limited. This is because there’s a one-month gap in the expiration dates. For example, let’s say the stock drops to $30 in November and continues to $27 in December. We’ll have a $600 loss on our assigned shares because we bought the stock at $33, but our long put will be in the money $600, leaving us with a loss of just our $50 initial premium.
The calendar spread is a great way to profit from sideways movement now in a stock we expect to decline. While shorting a stock opens us up to potentially unlimited losses, with this strategy, we cannot lose more than we originally paid to enter the trade. And if the short put expires worthless, the gains on our long put can be substantial.