A troubling earnings report and stock chart sets shares of Red Hat (NYSE:RHT) up for lower prices ahead. But if you’re going to join the bear camp, an intermediate-term put vertical is the gear of choice for investors looking to short RHT stock with limited and reduced risk.
Let me explain.
Enterprise software outfit Red Hat tumbled roughly 6.5% Thursday on the heels of Wednesday night’s disappointing earnings report for its second quarter. On the plus side, the confessional featured revenue growth of 14% for RHT stock and a 3-cent-profit beat on earnings of 85 cents per share. Now for the bad news or at least the wrath of Wall Street.
Red Hat narrowly failed to meet Street sales forecasts of $830 million with actual revenues of $822.7. Revenue from training and services also came up short of estimates with a figure of $100 million versus $104 million. But that’s not all.
Guidance for RHT stock’s third quarter and full-year were also revised modestly below Street views with the company citing currency headwinds. And with some analyst concern of a weaker renewal base for the company’s bread and butter Red Hat Enterprise Linux (RHEL) subscription model, 5% short interest and a worrisome-looking RHT stock chart; there may be more to a still-unfolding bearish narrative.
RHT Stock Monthly Chart
Since the lows of the financial crisis, RHT stock has been one of the market’s behind-the-scenes large cap stars. Shares haven’t enjoyed the same coverage as competitors like Salesforce (NYSE:CRM) or Microsoft (NASDAQ:MSFT) for that matter, but Red Hat’s gain in excess of 1,500% from the abyss of the financial crisis nearly a decade ago speaks louder than words.
Still, there comes a time when even the best stocks correct on the price chart. So far RHT stock has dropped 26% from its all-time-high of $177.70 set in June. That’s a fairly common decline. But with Red Hat’s weaker guidance, subscription concerns, small but noteworthy short interest and a growing technical threat in the form of a bearish flag continuation pattern, a larger and more troubling correction for RHT is anticipated.
Red Hat Stock Options Strategy
In anticipating a larger correction will play out in RHT, but appreciative shares are a bit oversold near-term and technical forecasts can go awry, a below-the-market put vertical looks interesting while limited and vastly reducing trader’s risk.
After reviewing RHT stock’s options board and shares at $133.81, the Dec $125 / $110 put spread for up to $2.75 is favored. This position ensures exposure is contained to about 2% of shorting shares, which in a sometimes volatile stock like RHT, is definitely appreciated.
The break-even on this vertical at expiration is $122.25. That’s about 8% below current levels. However, profits could come much sooner. If RHT stock drops in price prior to the third Friday in December, time value can help increase the market price of the spread while still being out-of-the-money.
If the value of this put vertical does begin to build, this spread trader may also look at adjusting the position to lock in profits and/or further reduce risk or redesign the position as conditions change. One of my favorites is to turn a vertical into some type of butterfly configuration.
Lastly and optimistically, well in a bearish sort of way, if Red Hat shares get hit hard and are wedged below $110 and into a trio or cluster of Fibonacci levels from about $105 to $119, this strategy enjoys a maximum payout of $12.25 or 445% at expiration.
Disclosure: Investment accounts under Christopher Tyler’s management do not currently own positions in any securities mentioned in this article. The information offered is based upon Christopher Tyler’s observations and strictly intended for educational purposes only; the use of which is the responsibility of the individual. . For additional market insights and related musings, follow Chris on Twitter @Options_CAT and StockTwits.