This morning, I am recommending another bullish trade to take advantage of the healthcare sector, which hasn’t caught up to the rest of the market. After its last earnings report, Johnson & Johnson (NYSE:JNJ) looks like a good target for a cheap ratio call debit spread.
Daily Chart of the Health Care Select Sector SPDR Fund (XLV) — Chart Source: TradingView
Eventually, I think the sector will continue heading higher. JNJ is in an interesting position after its latest earnings report, and I think it will start to head higher with the rest of its sector.
Good Earnings and Bad News Coverage
JNJ reported earnings last week, and it beat both earnings and revenue expectations. It also increased its revenue guidance for 2019 from a range of $80.4-$81.2 billion to a range of $80.8-$81.6 billion.
This is generally positive, but the company is also back in the news because the lawsuit over whether JNJ’s talc-based baby powder products caused cancer in some consumers is moving forward. There was a key hearing earlier this week, which will determine whether or not evidence from expert witnesses from both the company and the plaintiff is scientifically sound.
If the hearing goes well, it would provide a way out of almost 11,000 cases. Because the company has had mixed success winning these cases in the past, that would be good news.
These lawsuits have been bad for JNJ’s stock price, and they have even put a financial strain on its talc supplier Imerys, which filed for bankruptcy. JNJ was down before earnings, and the positive report may have prompted investors to exit the trade and limit their losses while things looked good.
A Longer-Term Strategy
JNJ has been climbing back up ever since late 2019. You can see JNJ dropped in the run up to earnings, and it continued falling afterward. It is starting to establish support at the $128 level though, and it may turn around and head higher going into August.
Daily Chart of Johnson & Johnson (JNJ) — Chart Source: TradingView
I think the move lower this week was overdone. JNJ’s outlook for 2019 was positive before its last earnings report, and its only getting stronger.
Over the next month or so, we may see the stock start to recover. Many investors are looking for attractive stocks with strong dividends, and an underpriced JNJ fits that description.
If it does head higher, we may be able to collect a nice profit using a cheap call debit spread.
Using a spread order, buy to open 1 JNJ Sept. 20th $135 call and sell to open 2 JNJ Sept. 20th $140 calls for a net debit of about $0.35.
Note: Be sure you are opening the monthly JNJ options that expire on Friday, Sept. 20, 2019.
About Ratio Debit Spreads
A ratio debit spread is simply a way to lower the cost of buying options, as the two options that you sell to open (short) help offset the cost of the option that you buy to open. Therefore, this ratio call debit spread is a way to lower the cost of establishing a bullish call option trade. Many brokers will require the use of margin and/or a set amount of reserved capital to execute a ratio debit spread; contact your broker directly for specific requirements.
Because you are short a naked call in this ratio call debit spread, one risk is that the underlying stock could unexpectedly move up sharply. If that happens, we would need to buy back to cover and close the naked call option for a loss.
The other risk due to the naked call is if the stock moves up sharply the call could be assigned. This means that for every 1 call option we sold to open (shorted), we would need to buy 100 JNJ shares on the open market at an unknown higher price and then sell the shares at the $140 strike price for a loss. So, this is inherently a higher risk play. Keep your positions small.
Ken Trester is editor of the popular Maximum Options program. Trester has been trading options since the first exchanges opened in 1973 with a winning streak that goes back to 1984 with money-doubling average annual profits since 1990.