Red Hat (NYSE:RHT) reported earnings last night and Wall Street absolutely hated what they saw and heard. The options markets were only expecting a +/-$8, yet the stock is falling $23-per-share on the headline.
RHT management beat on both the top- and bottom-line. But as is customary these days, 2018 guidance was below consensus so investors are disappointed. The conference call made things worse as management noted competition to RHT services from customers running services in containers.
The problem is that they failed to identify the scope of the threat. They know it’s there but don’t know how big or who is using it. This tells me that they can’t fix the potential problem not knowing where to turn or how bit it is. From an investor’s point of view this equates to new uncertainty to price into the stock.
Luckily for investors, Red Hat stock came into this earnings event up 34% year-to-date, which was in-line with Salesforce (NYSE:CRM). It’s not the case that investors are unwilling to buy up a stock from an elevated point, as we saw excellent reaction in CRM and Micron Technology (NASDAQ:MU) stock on earnings headlines.
This dip comes after a recent downgrade citing high valuation. So maybe the author of the downgrade was right, but now that 12% of froth just came out of the stock, there may be an opportunity to profit from the long side.
Momentum stocks rarely offer perfect entry points. On the way down, stocks like RHT look headed into an abyss. Today’s dip is an opportunity to profit from the long side in this positive macroeconomic situation.
No, I won’t buy the shares outright this early to try and catch this falling machete. Moves this big often last for three days. So I do sell downside risk into what others fear. And on red days like today, the put premiums are over extremely high.
Fundamentally, RHT stock sells at an 80 price-to-earnings ratio, so it’s definitely not cheap. There could be more red days ahead and still won’t create a cheap reason to enter the stock. Today, I bet against what should be clear levels of potential support against, which I can lean to generate income.
It is important to note that I stand to profit even if we don’t get a bounce in RHT. All I need is for the price to stay above my level and I retail my maximum gains. But the worst case scenario is that I own RHT stock at a severe discount even from today’s levels.
The Bet: Sell the RHT Dec $105 naked put. This is a bullish trade, where I collect $1.80 to open. Here, I have an 80% theoretical chance of success. But if the price falls below my strike, then I accrue losses below $103.20.
Selling naked puts carries big risk, especially for a stock as frothy as RHT. For those who want to mitigate it, they can sell a spread instead.
The Alternate Bet: Sell the RHT Dec $105/$100 credit put spread, where I have about the same odds of winning, but with much smaller risk. Yet the spread would yield 15% if successful.
Click here for more of my market thesis and get an ongoing free copy of my weekly newsletters.
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.