Yesterday, the stock market moved on headlines from the U.S. Federal Reserve decision to raise rates. This morning, Applied Optoelectronics (NASDAQ:AAOI) is moving on its own set of headlines and it’s not looking good for AAOI stock.
Loop Capital downgraded it to sell and AAOI stock is falling 10% on the news. Loop Capital also lowered the price target to $20 per share, which is still considerably lower than its current price. Therein lies an opportunity to take the other side of this thesis.
I consider this to be a speculative trade inside a conservative portfolio, so I will set a short leash on it and I won’t let a trade become an investment.
Fundamentally, AAOI is not bloated, as it sells at a 20 price-to-earnings ratio for the trailing 12 months. There is room to fall but it’s not an outrageous overvaluation. This downgrade is more for future hurdles than the current situation on the stock.
Today’s setup in Applied Optoelectronics stock is a purely technical attempt to catch this falling machete. This is a stock that has a high short interest and, for now, it seems that the bears are right about it.
I am not here trying to catch a bounce in AAOI stock, but rather bet on the floor below. This is a stock that has fallen 17% year-to-date with no signs of stabilization. So I will use options to limit my exposure and build another buffer, even from this morning’s drop.
How to Trade AAOI Stock on This Dip
I usually require value in order to sell downside risk into it. But in this case it’s a pure bet against price action, so my conviction is low. This means that I have to have the discipline to raise the white flag if the price action goes against me.
The first level of support should be around $27.50 and below it comes this year’s low of $23 per share. AAOI management reports earnings early November, so it will be interesting to see what they have to say about the impact of the tariff Wars on their business.
Depending on the price action between now and then, I may need to defend the position through the earnings event with shorter-term options.
Meanwhile, I will use today’s trade to try to generate income without any immediate out-of-pocket expense. This is a rinse-and-repeat trade for me on almost exactly the same setup months ago.
The Bet: Sell the AAOI Jan 2019 $17.50 put and collect 50 cents per contract to open. I have a 85% theoretical certainty so that I retain maximum gains. Otherwise, I will accumulate losses below $17.
Selling naked puts carries big risk, especially for a stock as frothy as AAOI. For those who want to mitigate it, they can sell a spread instead.
The Alternate Trade: Sell the AAOI Jan 2019 $17.50/$15 credit put spread, where there is about the same odds of winning but with much less risk. Yet the spread would yield 15% if successful.
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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.
