The Spread Trader: Bear Put Spread On Chipotle Mexican Grill (CMG)

| May 21, 2012 | 0 Comments

CMG OptionsYou’ve probably noticed investor sentiment has taken a bearish turn of late.

The bullish momentum that carried the Dow 25% higher from around 10,500 in October to over 13,000 earlier this year is gone.  It’s been washed away by the problems in Europe and weaker than expected economic data in the US and China.

Obviously, when investor sentiment turns as bearish as it has lately, it is bad news for stocks… but it’s even worse for high flying growth stocks.

You see, a good growth stock will often skyrocket in value when investor sentiment is bullish.  It’s not uncommon for the stock of one these market darlings to reach an astronomical valuation when things are good.

But here’s the problem…

When investors turn bearish, these high flying stocks are usually the ones that fall the hardest.

The reason’s simple…  If economic growth isn’t keeping pace with the lofty expectations that fueled their high valuation, then the bullish case for the stock just doesn’t make sense.  So investors hit the sell button to capture their profits.

Right now, we’re seeing this play out in Chipotle Mexican Grill (CMG).

As you know, CMG operates a chain of fast growing Mexican food restaurants.  And investors have fallen in love with the stock because of their ability to grow revenue and earnings.

Amazingly, revenue has grown at more than 22% per year over the last five years.  And earnings per share have grown at nearly 40% per year.

CMG’s strong growth has fueled a massive 381% increase in the stock over that time.  In the last year alone, CMG shot up more than 50% from $275 to a recent high of over $430 per share.

But here’s the thing…

The stock’s strong performance ran ahead of the fundamentals.  Even after falling 10% since April, the stock is still extremely overvalued.

At a recent price of $392, the stock has a P/E ratio of 54.  That means investors are paying $54 for every $1 the company earns.  That’s pricey in any industry.  And it’s 2.5x times higher than the restaurant industry average.

Clearly, CMG is a perfect example of a high flying growth stock. Investors ignored the fundamentals and bid up the stock of this market darling to an unsustainable price.

As expected, once investors turned bearish, CMG has taken a big hit.  The stock has fallen more than 10% from the 52-week high to around $392.

And there’s still plenty of downside in CMG.  In fact, the next level of support where buyers will likely step in is at $350.

This looks like a great opportunity for a bear put spread on CMG.  This bearish strategy is made by buying one put option and selling another put option at a lower price.

Here’s what to do now…

Buy the CMG July 2012 $380 put for $15.80 and sell the CMG July 2012 $350 put for $7.69.

Remember, when buying a put spread, the maximum profit is the difference between the strike prices minus the amount paid for the spread.

This trade costs us $811 ($1,580 – $769) per contract.  Our breakeven on the trade is $371.89.  If CMG is trading at exactly $371.89 on July 20th, we’ll get our $811 back.

We’ve also limited our risk to our initial $811 investment.  If CMG is trading above $380 on July 20th, we’ll lose $811.  But no matter how high CMG goes, we can never lose more than our initial investment.

Now for the good part… profits!

Our maximum profit of $2,189 comes if CMG is trading at or below $350 on July 20th.

In other words, we’re risking $811 for a chance to make $2,189.  And according to our tracking system, there’s a 33% chance of this trade making money.  That’s a good risk/reward in my book.

Good Investing,

Corey Williams

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Category: The Spread Trader

About the Author ()

A former banking executive, Corey Williams is the Chief Options Strategist and co-editor of our well-known daily newsletter, Options Trading Research. Corey’s extensive experience with options goes all the way back to his days in corporate finance. It was this decade in banking where Corey discovered the most important skill an options trader can have– the ability to analyze a company or sector to determine its likely future direction. And now he’s brought this background, experience and love of options to Options Trading Research, the unique daily e-letter devoted exclusively to helping individual investors profit from the very lucrative options market.