Should You Chase Winners?

by: optionMONSTER

By David Russell

The way I see it, there are essentially two trades facing investors right now: whether to chase winners or look for opportunities among unloved growth names.

On the one hand, we have low-risk stocks like utilities, drug makers, and consumer-product companies--the ones you hear constantly touted for being "high-quality" and paying "big dividends." On the other, we have many companies that are trading near 52-week lows that seem to be bottoming out, especially industrials and certain technology names.

American investors have grown so paranoid about things that go bump in the night--European debt blowups and Chinese economic data, for example--that we have been forced into stocks with extreme safety. They have sought investments that resemble bonds as much as possible because they have little risk and pay income.

These safety names essentially amount to little more than "high-beta" Treasuries, and I believe that they need to be understood as such. If Treasury yields start to rise and risk appetite returns, companies like Consolidated Edison (NYSE:ED), Altria (NYSE:MO), and Kraft (KFT) will slow down or reverse. The focus will then shift to beaten-down growth names that stand to benefit from a stronger economy.

At the same time, certain industrial and material stocks have been sitting and waiting for the last couple of months. Most of them, including Ingersoll Rand (NYSE:IR), U.S. Steel (NYSE:X), and Terex (NYSE:TEX), have been nudging their way higher since October but remain trapped against their 100-day moving averages. If sentiment improves and risk appetite return, these could really run.

One potential strategy is a butterfly spread on X: You could buy one January 31 call, sell two January 33 calls, and buy one January 35 call, for a total cost of $0.09. This strategy will start making money in a hurry if X pushes above $31, with a maximum profit of more than 2,000 percent if the stock closes at $33 on expiration. (See our Education section)

The trade has a big potential reward but low probability of success because X is currently around $26, so would have to rally more than 25 percent for the maximum profit to be realized. The reason that I suggest it is that, when a stock like X starts to move, a 25 percent gain in a single month is completely possible.

The steel giant is always a good name for a complex strategy like a butterfly because it trades a ton of options and therefore has tight bid/ask spreads. Always remember that the more pieces a trade has, the more it will cost you in both commissions and bid/ask spreads.

Ford looks similar to X and has been pushing higher since October while trying to break its 100-day moving average. It also has tight option spreads.

A few others worth checking out include:

  • Huntsman (NYSE:HUN): This stock has been holding support around $9.40 and beat expectations the last time it reported on Nov. 2.
  • NXP Semiconductor (NASDAQ:NXPI): It has seen bullish call buying in recent sessions, with a potential catalyst from Google Wallet.
  • Rite-Aid (NYSE:RAD): The company's turnaround seems to be gathering steam and management raised guidance on Dec. 15.
  • Clearwire (CLWR): It recently signed a new contract to provide networking services to Sprint Nextel and raised capital. That takes bankruptcy off the table. Shares are stuck at their 100-day moving average, but a 50 percent move to $3 looks imminently doable.
  • Las Vegas Sands (NYSE:LVS): This name has spent all of 2011 consolidating after a big move in late 2010. Look for it to make a higher low above $40, then go to its 52-week highs around $50 and consolidate, followed by a breakout and new highs.
  • Goldman Sachs (NYSE:GS): I have hated the financials for a long time, but this one looks like it's done going down. It's probably not ready to rally yet, so I would wait for its 100-day moving average to come down to the stock and then look for break.
  • Whirlpool (NYSE:WHR): This stock trades for less than book value and will benefit from better housing and employment. But it's probably not ready to move yet. Like GS, you want to wait for the 100-day to come down and then look for the stock to break through.

Overall, the boring safety names may continue to lead early in 2012, so it could make sense to wait for pullbacks in those in the near term. But at some point sentiment will return to growth.

Be ready for that shift to occur, because when it does the picks identified here could strongly outperform.