I have been asked how I make the decision to create a debit spread trade on a company. I am going to share some insight into how I make observations using data from analysts to make a decision on what to do.
We are going to use Cisco (CSCO) as an example. We are going to look at what analysts think of the company and make some observations. To observe means to notice what is happening. Our observation on lt need to be general. We don't need deep specific details on trades like these.
What do Analysts Think
Cisco is presently trading at 20.50. I want to know three main things.
- What is the projected 52 week price range?
- Has the stock been upgraded or downgraded in the last 60 days and why?
- Is there a trend in the analyst's outlook for the stock?
I use Yahoo Finance for this information.
Projected 52 week price range- 22.58. Our first conclusion is that the stock can move another 10% before it reaches this level. Therefore we are close to what is considered its 52 week high.
Up/down-grades- Cisco was downgraded twice on 2/9/12 by ISI Group and MKM Partners. Now if I can find out why, it may paint a better picture for me on where I believe the stock will be moving. They were downgraded from buy to hold. This means they do not think Cisco will keep going up much longer. I want to find out why.
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MKM Partners were concerned with a disappointing revenue growth of 7%. What they call 'order deceleration' raises concerns of revenue growth. They dropped their price forecast from 25 to 22 in February.
ISI Group said the downgrade is a valuation call. They are not expecting the stock to rise much more at all.
When I look at this information, I am observing that the analysts do not believe Cisco will move up much longer.
Analyst's Trends- Looking at the 3 month charts, it looks like a mild trend toward hold. Remember these are just general observations. This supports the idea that analysts are gravitating toward the idea that the stock will peak soon.
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This is just one system to use in our evaluation and observation time that allow us to draw these observations:
- Cisco does not have much more to go before it reaches it's expected 52 week high. Maybe 10%.
- It has fallen out of favor as a growth stock with analysts.
- Price projection was recently downgraded from 25 to 22.
- Revenue growth is below expectations.
If we just used these observations and wanted to make a vertical spread play on Cisco, we would initiate a Bear Put Spread.
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Taking into account where the stock is now, we would be looking for a pullback. Since it is trading in a zone and has been since mid January, we would look the following trade:
The Option Trade
- Buy an October 2012 '20' put option (priced at $1.42)
- Sell an October 2012 '19' put option (priced at $1.02)
- Net Debit to Start: $0.40
- Maximum Profit: $0.60
Reasoning behind the Trade
- The stock is at the top of the Bollinger Bands and tends to move to the bottom of the band.
- This is within our trade range.
- Analysts do not believe the stock will move up much more.
- Unimpressive revenue growth could put a damper on further growth.
- Its very close to its expected 52 week high.
- October gives us room for the stock to move a bit more if it anted to before it pulls back.
This is just one part of an observational process a trader can use to evaluate how to make a debit spread trade using options on a stock.
