Shares of Square Inc (NYSE:SQ) finally had the long-awaited selloff yesterday. SQ dropped a stunning 16% in one day after the stock had doubled since the late August lows. While some may look at yesterday’s carnage as a buying opportunity, I take the opposite viewpoint. Now that the highs are clearly in for SQ, it is time to sell any future rally in Square.
The impetus behind the brutal drop was a note and a downgrade from BTIG analyst Mark Palmer highlighting valuation concerns regarding SQ. He feels that while Square has certainly grown and beaten estimates, shares had simply become too overheated.
The cryptocurrency craze was the driving force behind much of the rally and is likely unsustainable. Mr. Palmer lowered his rating to a “sell” with a $30 price target, implying more downside on the horizon.
Certainly SQ had gotten to extreme readings on a technical basis as well. The 9-day RSI had reached an almost unbelievable 95 before the big drop while MACD was at a ridiculously high level as well. Certainly the parabolic price action was also indicative of a blow-off top.
SQ options had also displayed attributes consistent with euphoria as well.
Normally, out-of-the-money puts carry a higher implied volatility (IV) than similar out of the money calls. Prior to yesterday’s massacre, the IV on the out of the money calls was trading at a substantial premium to the out of the money puts.
This reverse skew is usually a harbinger that the stock has reached an extreme and a reversal is looming. That certainly was the case in SQ stock.
Now that the highs are in and the momentum has clearly been broken in Square, every rally should be sold. Option prices are at the highest levels of the year (98th percentile of IV) owing to the recent volatility so selling strategies are definitely the preferred way to structure a trade. A simple out-of-the-money call credit spread makes a lot of sense to me.
SQ Stock Trade Idea
Buy SQ Jan $50 calls and sell SQ Jan $48 calls for a 40 cents net credit
Maximum gain on the trade is $40 per spread with maximum risk of $160 per spread. Return on risk is 25%. The short $48 strike is positioned near the all-time closing high of $48.86 in SQ and provides a 17% upside cushion to the $41.02 closing price of Square.
As of this writing, Tim Biggam did not hold a position in any of the aforementioned securities. Anyone interested in finding out more about option-based strategies or for a free trial of the Delta Desk Research Report can email Tim at firstname.lastname@example.org.