Stock Heading To Zero… What To Do
Sometimes a stock has been beaten down so much that it seems destined to hit zero.
However, even if we are eventually right about the direction, it can be very difficult, if not outright dangerous, to attempt to profit from this type of situation before the company goes bust.
Why, what’s the risk? One of the big issues is the inherent short-selling risk on low-priced stocks. Even when stocks seem to be in a death spiral, they still have theoretically unlimited upside potential.
For example… Dendreon (DNDN) is one company that comes to mind as I’ve watched it pop from single-digit prices on more than one occasion over the years. I remember seeing the pharmaceutical firm trade around $4 a share with huge short interest while waiting for a regulatory decision on one of its proposed drugs. Now, you can probably guess what happened. The ruling was positive, and the shorts got squeezed as the stock jumped above $20 a share in a very short time. What’s more, this happened in March 2007 and again in April 2009, when shares eventually ran up to $57 from a low of $2.55.
So, how can you play this type of situation? Of course, one alternative in approaching such names is to use options. Buying puts is a limited risk way of betting on that zero price target, but the problem there is the cost. When stocks get very cheap, the volatility is usually very high, making the option premiums a poor choice.
Here’s another example of a company with high priced premium problems… Just the other morning, Zynga (ZNGA) was trading at $3.08 a share. And believe it or not, someone was selling the ZNGA March $2.50 strike put options for $0.42. The trader may end up obligated to buy the stock if it trades below the $2.50 strike, but the effective purchase price would be $2.08. If the trader is hoping only to make money on the puts and not get long, the stock price would need to be below that level at expiration for the options to profit.
So why even mess with these types of names? These two cases highlight the big issue with stocks that are struggling in the low single digits, but are potential takeover targets according to analysts. Publicly traded companies have value to someone, regardless of how low their stocks go. And bargain-hunting suitors will find such names even more attractive as their share price descends. So just when a stock seems to have no hope, that may actually be the optimum time for it to reverse higher. Perhaps in a very big way, especially if the acquirer offers a generous price.
Bottom line… Mere rumors of a buyout often catch short-sellers off-guard, lifting an otherwise “worthless” stock, if only in intraday trading. So from a simple probability standpoint, you are almost always better off selling puts in such cases rather than buying them. Moreover, if you think that a stock is going to zero, you probably aren’t alone. And whenever you share the consensus opinion, it’s usually more difficult to make money. Always remember, the best opportunities come when you think that the market is wrong about something and have a thesis based on your research.
Otherwise, you’re just gambling!
Safe Trading,
Marcus Haber
Category: Options Trading Basics
