Trades

Profit Opportunity on GE’s Wild Ride

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One of the world’s most widely-held stocks has been a sore spot in investor portfolios over the last year. General Electric is many things to many different people. The maker of washing machines, turbine engines and MRI machines has been in turmoil.

Last year, the company suffered a credit rating downgrade to just a few notches above junk status. That was an eye-opener for investors everywhere.

Investors fled the industrial giant following this downgrade. But as you can see, they quickly had a change of heart to start 2019:

While everyone seems to have an opinion about whether General Electric is still a buy, its important to look at what’s really going on for this Wall Street titan.

The cause of that initial downgrade in October was the company’s debt load. After decades of aggressive buying and merging, GE got its hands into just about every industry you can imagine: industrial, financial, healthcare, transportation and technology to name a few. But it did so at a cost.

It had piled up more than $110 billion of debt to finance all of that consolidation and cross-industry investment. That’s an enormous amount of money even for a government. But for a company, that’s nearly unheard of.

Standard & Poor’s, Moody’s and Fitch clearly saw this as a problem. That’s why they downgraded the company’s credit rating to just above junk levels.

To top things off, the company also hired a new CEO in that period. And his role, as he sees it, is to undo much of what GE has done in the several decades before him… sell off ancillary businesses that GE shouldn’t be involved with in the first place.

Obviously, this kind of situation has investors on the edge of their seats… and for good reason. From day to day and hour to hour, no one is quite sure what a trimmed-down and deleveraged GE would even look like… let alone how it could do that.

This new CEO, Larry Culp, has promised investors that the company will spinoff, sell-off or get rid of everything from its healthcare business to its banking division – the very one old Jack Welch was so proud of.

As the first of these major spinoffs started to come into focus in the first two months of 2019, investors regained some hope in GE and this new CEO. From their ominous bottom of $6.66 in December, shares are up more than 59%. You just don’t see that kind of movement in a stock so widely held often.

They still haven’t fully recovered. But yesterday’s massive $1.40 gap up certainly helped. The reason it jumped so much at yesterday’s open was on the very news investors have been waiting for.

General Electric announced it agreed to sell its BioPharma business to Danaher Corporation for $21.4 billion – almost all of it in cash. This business is part of its enormous healthcare group and focuses on tools of the trade used in drug development – equipment, software, etc.

Clearly, the company needs that cash. And investors have been waiting for a story like this one. $21 billion in cash doesn’t dig GE completely out of its massive hole. But it does make a nice dent in that $110 billion debt load.

This latest move just adds to the company’s great recovery since that low in December. But the real question for investors is: will this momentum continue? Or, will this just be another false recovery in the company’s clear downward trend?

For us, it actually doesn’t matter. You see, there’s only one thing about GE’s share price that anyone could say with confidence: it is going to stay volatile for a while.

There’s a way to play this kind of volatility. In fact, there’s a strategy that lets traders profit no matter which way GE’s shares head from here.

If this divestment truly helps the company recover its core business without credit risk, great. If it doesn’t and the company is losing out on much needed income streams this business provides, that’s fine too.

As long as something happens, and shares continue to gyrate, this strategy works.

Let’s get into it…

A Strategy For GE’s Price Volatility

A long strangle is a type of options trade that involves both an out-of-the-money call option and an out-of-the-money put option. The idea is that shares can move either up or down and you still have a profit opportunity.

The way it works is by buying one of each with the same expiration date. Since this trade involves buying two contracts, it is a net debit strategy. Meaning it costs money to enter into this trade. But that initial entry cost is the whole amount you’d have at risk for the duration of the trade.

For that price, however, the maximum profit potential of a long strangle is limitless. Both the put option and the call option offer explosive amounts of returns if shares of the underlying stock move greatly.

You can see how this type of trade works here:

Source: The Options Industry Council

As you can see, the only way to lose money on this type of trade is if the stock just doesn’t move in price. For a company like GE, that has vacillated between extremes for many months, that’s not likely.

Let’s look at a specific example to see what kind of opportunity exists with this trade…

A Specific Long Strangle Trade in GE

If a trader wanted to get in on this opportunity with GE, he could buy a March 15 $11 call option for $0.34 per share and then buy a March 15 $10.50 put option for just $0.13 per share. His entry cost would be $0.47 per share. Since each of those options is on 100 shares of GE, that’s a total net debit of $47.

That $47 is all the trader stands to lose if shares of GE don’t move from where they are right now. Again, that’s not likely. But even if that happens, $47 isn’t a whole lot to put down for the potential you get in return.

If shares move just a little bit from where they are, this trade would quickly turn into a gain. To find those profit points, simply compare the entry cost to the strike prices.

If shares continue to climb as they have, our hypothetical trader would have himself a profit when they passed $11.47 per share. That’s just the call’s strike price plus the cost to enter the trade. Anything higher than that would be pure profit.

If shares fell, however, our trader would profit as they dropped below $10.03. That’s just the put’s strike price minus the entry cost.

Clearly, this kind of trade costs very little, but has tremendous potential. No one can truly be confident whether GE will continue its recovery or if the selloff will pick up again. But we can be sure that it isn’t going to sit where its at and wait around.

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