The stock market this morning is setting new all-time highs, especially the S&P 500, yet Red Hat (NYSE:RHT) stock is down 5.7% to $134.79. Investors did not like what they heard on Red Hat’s earnings call Wednesday. This is becoming a habit for RHT stock, but this time the punishment is not as severe as the beating RHT took three months ago.
Even though the company grew revenues 14% year-over-year, they missed the estimates on it. The good news is that they managed their expenses well to beat the bottom line forecast. RHT guided below forecast going forward, however, which is unacceptable on Wall Street.
The good news is that Red Hat does appear to be attracting bigger clients, but for now, the transition is affecting its overall sales figures. Fundamentally, at a price-earnings ratio of 60, Red Hat stock is not cheap. It’s no bargain. Instead, I consider this a speculative play on the price action of a decent stock.
We are fast becoming completely dependent on technology for all aspects of our lives. RHT is a supplier to that tech especially the could. So its long-term prospects are viable. These short-term hiccups are temporary for as long as management continues to execute on plans. So for now, dips are trading opportunities.
Since the stock market is near, or at all-time-highs, I worry about the upside potential. I am still optimistic about the overall macroeconomic picture, so there is an opportunity in creating income from RHT stock in the midterm. Mainly, by using the options market to sell downside risk into the earnings disappointment.
Technically, Red Hat stock is a risk. Below $130 per share, it could trigger more selling for another $12. That’s why it is important to use options instead of buying the shares outright. There I can create a buffer between the current price and my level of risk.
Luckily for investors, Red Hat came into its earnings event up 20% for the year, which is better than the Nasdaq PowerShares QQQ Trust ETF (NASDAQ:QQQ).
And the experts on Wall Street expect higher prices for RHT since it is trading below their average price range. I have more faith in the downside support holding than the upside hopium coming to fruition.
Red Hat Stock Options
The Trade: Sell RHT Jan 2019 $110 naked put and collect $1.5 to open. Here I have an 85% theoretical chance of retaining maximum gains. If the RHT stock price falls below my strike, I accrue losses below $108.50.
Selling naked puts carries big risk especially for a momentum stock like RHT. For those who want to mitigate it, they can sell a spread instead.
The Alternate Trade: Sell RHT Jan 2019 $115/$110 credit put spread. The spread has the same odds but would deliver 12% yield on risk. Neither trade requires a rally to profit.
It is important to note that today’s trade doesn’t need a rally to profit. I simply need support for RHT stock to hold for the near term. Time will then do the heavy lifting and premiums will expire in my favor. But just in case, I have to be ready to own the shares at that level.
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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.