Options

Is Big Blue A Big Buy?

By Lee Lowell  |  November 7, 2018

This past October, International Business Machines (IBM) set a record for itself. In one month it dropped the most in its history.

It unloaded $40 per share, from its high of $154 on October 3 to its low of $114 on October 31.

Ouch!

Happy Halloween! Or was it?

I watch stock charts all day long and I researched data going back to the 1970s. The only other time IBM dropped this much in one month was in October 2008, when it fell $38 per share.

I can understand the big drop in 2008, but what gives this time around?

Bucking the Trend

Apparently, the stock has been in a downtrend since early 2013, bucking the uptrend of the overall market.

IBM has lost roughly 47% in that time frame while the Dow Industrials has gained almost 90% and the S&P 500 has gained roughly 95%. A huge discrepancy and disappointment for Big Blue, for sure.

And when IBM announced earnings a few weeks ago, on October 16, it began the second half of its current freefall, to a low of $114.

Here’s a current chart.

However, no matter how much damage a company undergoes, it’s my experience, from watching the charts, that at some point, a stock has to bounce.

It’s like a rubber band that gets stretched too far in one direction and needs to snap back.

IBM is in that position right now.

Ready for a Snap Back

It got extremely oversold.

And since hitting $114 on Halloween, it has jumped back up to $120 per share.

But, from what the charts are showing me, I believe that bounce can go a bit higher.

Others disagree and think IBM is on its way out.

Whether or not IBM does go the way of the dodo bird (think General Electric), it’s too early to tell.

Big Blue is still a major player in the tech industry. It has its hardware (mainframes), its software (Watson), and its cloud computing. It also just made the biggest purchase in its history – the $34 billion acquisition of Red Hat (RHT).

Can that jumpstart a new uptrend?

We’ll have to wait and see. But if I had to make an educated guess, I’d bet on the upside from here. It’s just too oversold.

If you believe this may be turnaround time for Big Blue, here’s a new way to play it.

Options Have You Covered… In More Ways Than One  

I love to tout the amazing benefits of using options contracts as a preferred form of investing. Just check The Rich Investor archives here.

I typically discuss my two favorite options strategies – buying deep-in-the-money (DITM) call options, and selling out-of-the-money put-options.

But today we’ll discuss a different strategy… one that offers both a limited risk and a limited reward.

It’s one that can create current upfront income and also keep you in the game for extended periods of time, even if the stock moves against you.

Enter the genius of the vertical credit spread, otherwise known as either a bull put spread or bear call spread. One takes advantage of a bullish stock move and the other a bearish stock move.

In this case, we’ll look at the bull put spread, since IBM’s near-term direction looks higher.

Limited Risk, Limited Reward

One of the best features of an option spread is its limited risk, limited reward feature.

This means you can be absolutely dead wrong on the stock’s direction, and still only lose a smaller amount (which you know ahead of time).

When “selling” an option spread, you’ll be engaging two different options contracts in a single trade: a sale and a buy. The difference in their prices makes up the spread.

By selling the more expensive of the two (and buying the cheaper option), you’ll be taking in a credit to your account, hence, a “credit spread.” If you were to buy the more expensive of the two, it would be a “debit spread,” since you’d be paying out money.

In IBM’s case, we’re looking to create a bullish spread. To do this, we would sell a put option at one strike price and buy another put option at a lower strike price, collecting the difference (the spread).

With IBM near $120, the idea of selling a put option credit spread is to pick a price level where you think IBM will NOT fall to.

If you’re correct in that assumption, you’ll win on the trade and keep all of the upfront credit.

In the graphic above, we’ve priced out the April 2019 put options for IBM, giving roughly five and a half months for the trade to play out.

To create a hypothetical bullish put option credit spread, you would simultaneously sell the $90 put option for a fair value price of $0.99 per contract (splitting bid/ask) and buy the $85 put option for a fair value price of $0.69 per contract, creating a credit of $0.30 per spread. With the $100 option multiplier, this would place a credit of $30 into your trading account for each spread sold.

With IBM at $120 per share, you would retain the credit at expiration as long as IBM doesn’t fall below $90. IBM could rise, remain flat, and even fall to $90.01, and you would still walk away a winner.

What are the chances of IBM falling to $90?

Using our trusty probability calculator, we see that IBM has only a 4.35% chance of falling below $90 by April 2019. Conversely, it has a 95.65% of remaining above $90. I like those odds!

What if you’re wrong and IBM drops to $60?

Don’t worry, you’re covered!

The spread has a built-in fail-safe. You can never lose more than the distance between the strike prices, multiplied by $100. In this case, ($90 – $85 = $5) x $100 = $500.

If you are dead wrong at April 2019 expiration, you would lose $500 per spread, minus the initial $30, for a net loss of $470.

Yes, you’re risking $500 to make $30. But the odds are in your favor. IBM has a measly 4.35% of falling below $90. In the option’s world, that’s an excellent risk-to-reward.

With IBM extremely oversold, and the market moving into the most bullish time of the year, the bull put spread can be an incredible way to add upfront income to your account with a huge cushion for directional error.

The more you know…

Lee Lowell

A former Wall Street insider and floor trader, Lee Lowell has worked in the market for nearly 30 years now. He began his option trading career in 1991on the floor of the New York Mercantile Exchange (NYMEX) in New York City.MORE FROM AUTHOR