Something big is happen in the industrials sector, and investors are nervous. After a great first quarter by the likes of Honeywell International and United Technologies, 3M Company reported a disastrous one.
The company slashed its 2019 guidance this morning – the fifth such cut over the last year. Along with a lower guidance, 3M plans to cut 2,000 jobs.
No one seems to know what to make of all this. Some industrials are seeing a continuation of their good performance. Others, like 3M are seeing significant global problems. Europe and China are both seeing their own production numbers fall off sharply. And with a renewed surge in tariff talks between the U.S. and the rest of the world, it has many scared.
All of this comes at an absolutely terrible time for General Electric (GE). If you haven’t been following this sad saga over the last few years, it’s been rough for one of the most widely-held stocks in the world.
GE has been trying to shave off businesses it doesn’t feel are part of its core. After decades of building up groups like its healthcare segment and GE Capital, it has been working toward spinning those off. It hasn’t been easy.
The biggest spinoff – the one the made investors the happiest – came from its biopharma unit earlier this year. The company expects to bank $20 billion from the sale of this business to Danaher. But the rest has been going less smooth.
Over the past two years, shares of GE have floundered with this rough reshaping of the American industrial icon:
Even so, you can see in the above chart that the company did finally found a bottom at the end of last year. Shares are up 25% year to date.
But with the problems we’re seeing from 3M and others, it’s next to impossible to know what comes next for GE. If it follows its competitors Honeywell and United Technologies, this rally could pick back up. But if today’s 3M news foretells GE’s near-term performance, things could get ugly.
There’s no real way to know until Tuesday, when the company reports its own first quarter numbers. A lot will be riding on that announcement. Investors will see not only how GE has been able to perform in this rollercoaster environment. They’ll get an update on the company’s long-term divestment plans.
The outcome of this call will shape where the company heads for the rest of the year. Unfortunately, placing a bet ahead of time would be just that… a gamble.
We can’t know which direction GE will head. But we do know that it will head in that direction fast. Investors are not going to sit on a $9 stock that has already cut its legacy dividend payments forever.
JP Morgan downgraded the company already this month with a new price target of just $5. Others are calling for a rally as GE sheds its side businesses. So, all can agree on only one thing… GE is going to move.
Fortunately, there’s a way to play the size of price movement without betting on a direction for that movement. Let’s get right to it.
A Strategy to Play Short Term Volatility
A long straddle is an options trade that involves buying both a call option and a put option on the same stock with the same strike price and expiration date. It sounds counterintuitive. But it really does make a lot of sense… especially for likely movers such as GE.
As noted, this is an investment in price movement… not direction. If underlying shares fall, the put option will return enough to easily pay for the cost of both option contracts. If shares rally, the call option will bring home the bacon.
The idea is that one of the two legs of this trade will lose money. But the other will make so much, that it doesn’t matter. That way, you don’t have to be right in which direction a stock heads – almost a 50/50 guess with GE right now. You only have to be right that the stock will move.
You can see how this strategy works here:
Source: The Options Industry Council
It’s important to note that this strategy has a known amount of risk – the amount it costs to enter the trade – yet no limit on how much you can profit with it.
If GE were to somehow fall below that $5 price target set by JP Morgan, the put would pay out very handsomely. The lower the better.
On the other hand, if the company outperforms this first quarter and gets investors enthused about its restructuring again, the call could make a lot of money in a short amount of time. There’s no real limit to how much you could make on this kind of trade.
Of course, it’s not necessarily cheap to play both sides of this coin. To enter this trade, you do have to buy both a call and a put. But since shares of GE are under $10 right now, the cost isn’t going to break the bank.
Let’s to a look at a specific example of this kind of trade on GE.
A Specific Trade on GE
A trader looking to enter a long straddle on GE ahead of its earnings call next week could buy a May 17 $9 call for $0.56 per share and a May 17 $9 put for $0.40 per share for a net debit of $0.96 per share. Since each one represents 100 shares of GE, that’s a total entry cost of $96.
Now, that $96 is the most the trader could possibly lose on this investment. And he’d only lose that if shares of GE do absolutely nothing over the next month. As we said above, that’s just not likely at all.
The profit is nearly limitless. One of these two option contracts would go up in value no matter which direction GE heads from here… just as long as they move large enough. To find the point at which this investment starts to turn a profit, we have to consider both potential outcomes.
If shares of GE fall following the earnings call on Tuesday, this trade would be profitable as those shares drop below $8.04. To find that, take the strike price of the options and subtract the total cost to get into the trade ($9 – $0.96 = $8.04).
However, if GE surprises investors and shares rally, the trader would start profiting as they rose above $9.96. To find this one, you add the cost to the strike ($9 + $0.96 = $9.96).
With price targets ranging from $5 as mentioned earlier up to $18 per share, analysts only agree that GE will move… not the direction. Whether we’re looking at a $5 stock or an $18 one, this strategy would profit in a big way.