Broadcom Ltd (NASDAQ:AVGO) has been in the news for the past few days. The headlines have been of potential buyout of Qualcomm, Inc. (NASDAQ:QCOM). Both stocks are rallying on those prospects. I don’t believe it will eventually happen, so I want to short AVGO on that notion.
Before you send out calls for my arrest, this is not a dis against either company’s prospects. In fact, I will use the value that I see in AVGO stock to completely finance my bet.
Yes, this is a “bet” because my entire thesis is that the headline will fade, so the outcome is binary. And just like Las Vegas, binary trades are more gambling than investing.
Fundamentally, there is no doubt that the financial metrics for AVGO suggest that it is expensive. Its price-to-earnings ratio is almost 300 and it runs negative net margins. Even its price-to-book value is double most other stocks in the sector.
In today’s bearish bet I am not trying to short it because of valuation. I realize that in this uber-bullish stock market traders don’t care about aggressive valuations.
Click to Enlarge Technically, AVGO stock is flying high, as it’s up 60% year-to-date. Although it’s not as high as NVIDIA Corporation (NASDAQ:NVDA) which is up over 90%, but it is twice as much as the PowerShares QQQ Trust, Series 1 (ETF) (NASDAQ:QQQ).
Expectations for AVGO stock are high. Even after this spike, the stock is still near the low end of Wall Street’s lowest price target and 8% below the average. Furthermore, all analysts who cover it have a BUY rating on it. So clearly the boat is tipped to one side.
This leaves it vulnerable to surprise negative headlines. Although this is not a forecast for one but with this spike, I favor this scenario; hence my bearish bet.
AVGO Stock Trade Idea
The Bearish Trade: Buy the AVGO Jan 2018 $270/$260 debit put spread for $3.80 per contract which is my maximum potential loss. This is a bearish bet that requires the stock to fall through it for the opportunity to more than double my money.
To mitigate my out-of-pocket risk, I want to sell naked puts against eventual value in Broadcom stock. This makes my bet today against the price action, not the company prospects.
The Bank (Optional): Sell the AVGO April $220 put. This is a bullish trade for which I collect $5.50 to open.
By taking both trades, I get paid $1.70 to short AVGO stock. Ideally I need the price to fall through my debit put spread but not below my short put. And as long as the price stays above my sold put, any premium I collect from selling the debit put spread would be pure profits even if I sell for less than $3.80.
Ultimately, regardless of how careful I am, investing in stocks is fraught with danger, so I never risk more than I am willing to lose
Get my newsletter for free 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.
