Chipotle Mexican Grill, Inc. (CMG) stock has dropped disproportionately to the markets, with CMG stock falling 50% off its mid-2015 highs. Amazing what an E. coli outbreak or two will do.
On the other hand, while the first couple of 2016 has been challenging for the equity markets, CMG stock has vastly outperformed. For the last two months, Chipotle shares have bounced hard off the bottom into a rising channel.
Fans of CMG stock are betting (hoping) that the fallout from the E. coli outbreaks is finally done.
I’m also mildly bullish on Chipotle, though since they never really found out the source of the outbreak, I can’t assume that it won’t recur. Still, the severe drop in CMG did give me levels against which I can trade.
The current trading environment presents us with many uncertainties. These days, markets are often trading on the headlines. Fundamentals almost don’t matter in the short term. This makes for tricky entry points that depend more on timing the oil price cycle than the equity’s fundamentals.
There is a way around this, though, especially in value propositions — companies with a tangible bottom where buyers will clearly step in on major drops from current levels.
Chipotle can be one of those companies — I just have to accept the risks of another -10% headline. In the long run, though, I believe CMG stock could shrug it off just like it did the E. coli outbreak.
What supported Chipotle’s rise to all-time-highs was the incredible strength of its comps, showing tremendous sustainable growth. This mainly was built on a reputation of delivering responsibly healthy food — something demolished by the E. coli outbreak.
I want to bet long CMG stock, but I don’t want to be caught chasing this 2016 bounce near its highs, so I’ll use options to extend my time frame. This will slow down price action and allow me to build room for error.
Trade #1: Sell the CMG Jan 2017 $260 Put
For this, I collect $4.50 per contract — 10% potential yield on margin requirement. Potential absolute yield is 2%. I have a 95% theoretical chance of success. By selling naked puts, I commit to the risk of being assigned Chipotle stock at $260 per share should it fall that much lower. If so, my breakeven point would be $255.50 per share.
However, there are special circumstances with severe bearish consequences that motivate me to hedge my long CMG trade. The E. coli outbreak directly damaged the main driver of CMG stock: the food quality that drove sales, which in turn drove the stock price. Now, management has an uphill battle to unwind the damage. It won’t be easy, and it will take many months.
So for the hedge, I choose to turn this trade into a short strangle.
Trade #2: Sell the CMG Jan 2017 $840 Call
For this, I collect an additional $4.50 per contract. Selling both the puts and the calls further tips the break even levels in my favor should anything go wrong.
I favor using long-distance trades in special situations. They buffer the short-term risk of certain tickers. Longer-dated trades are easier to manage especially in a momentum stock like CMG, and especially when surprise headlines are a possible risk.
Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities.
