Momentum stocks are scary enough to trade on good days. But on really bad days they are terrifying. Dare to catch Shopify Inc (US) (NYSE:SHOP), which is now a falling machete.
SHOP stock suffered a full correction in one day on the heels of a negative note from Citron Research, and it did so on extremely high volume. So this is not likely to be a one-day event. Going all-in bullish now may turn out to be a mistake. But I can enter long if I build a sizable buffer just in case I’m early in catching the falling machete.
Citron Research has a track record of damaging their target stocks but eventually the story fades and traders go back to trading the price action.
Wall Street likes round numbers and SHOP stock is now around $100. This should provide some support not just because it’s the century mark, but because it is a pivotal point. The battle over $100 per share started back in June. It took the bulls two tries and more than two months to finally break out of it. Here they are once again likely to do battle for it.
I don’t anticipate the support to be a hard line in the sand but rather a range. Often enough, prior resistance becomes forward support. And therein lies my opportunity. Instead of buying the shares and hoping for a rebound to profit, I prefer to sell downside risk against levels that are not likely to happen. Usually I match those with value.
In this case, I can’t argue for value when the company is operating in the red. Amazon.com, Inc (NASDAQ:AMZN) is frothy at 240 price-to-earnings ratio but at least it’s producing its own cash. SHOP is a very long way from that.
To make matters worse on the valuation front, Shopify stock is selling at 9.5 times book. This leaves me to find a level against which to sell my risk purely based on the price action at hand.
Yes, I am catching a falling knife and I understand that it’s risky. This is a speculative trade inside a conservative portfolio. So I must leave the size of it contained so that it doesn’t break my piggy bank or my heart if things go sour.
Click to Enlarge This week’s damage was caused by a cautionary headline from a known short seller. The question here is how will analysts who cover the stock react. Currently the experts are split between buy and hold ratings on SHOP. There’s no telling how many of them will flip and in which direction.
Currently this stock is trading under its average price target, so in theory there is both upside potential and downside. This is all to say that this indeed is a coin flip trade, but by using options and building a buffer I am tipping the odds in my favor.
SHOP Stock Trade Idea
The Bet — Emphasis on “Bet:” Sell SHOP Jan $65 put and collect $1.50 to open. Here I have an 85% theoretical chance of success. But if the price falls below my strike then I own the shares and will accrue losses below $63.50.
Not all investors want to sell naked puts, especially on a stock that is falling into an abyss. For those they can sell a spread instead.
The Alternate Bet: Sell SHOP Jan $65/$60. This is also a bullish and it could deliver 10% yield on risk.
Investing in stocks is risky, and regardless of how careful I am, I never bet more than I can afford to lose.
Learn how to generate income from options here. 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. You can follow him as @racernic on twitter and stocktwits.
