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Technology Cold War Produces a Short Term Opportunity at Cisco

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According to Barron’s, there’s a cold war brewing. It involves China and the U.S. but has next to nothing to do with the trade war and ongoing tariff talks between the countries’ leaders.

The last one between the Soviet Union and the West used espionage and soft power with the occasional hot wars throughout Asia. This one involves infrastructure, economic might, and most importantly technology.

While the threat of hackers from Russia and China remain a topic of much interest in political circles, the ground troops of this cold war are the companies involved.

On the tech side, there’s one area of much-heated competition: 5G technology.

At the Mobile World Congress this week, Cisco Systems CEO Chuck Robbins spoke frankly about this battle. Asked about his company’s Chinese rival, Huawei Technologies, Robbins told reporters, “We’re singularly focused on 5G, and have every confidence we will win. As for the other stuff, it is between the government and them.”

This touches on the real elephant in the room. Over the last year, the U.S. government, specifically the State Department, has been gunning for Huawei. In fact, with the help of Canadian police, the U.S. arrested the company’s CFO in December. Meng Wanzhou was charged with covering up violations of Iran sanctions.

Whether that charge is true is still not exactly 100% known. China is debating the issue, and it has caused one of the many rifts in the two countries’ negotiations.

Many suspect that the arrest was at least in part because of suspicions that Huawei may be in league and receiving some direction from the Chinese government to build a backdoor into U.S. and European 5G networks, of which it is the world’s leading developer.

No one has been able to prove anything like that. But the arrest kicked off an ongoing fight between the U.S. and Huawei. It doesn’t take an industry specialist to see who most directly benefits from this battle.

Cisco, once one of the fastest growing tech companies of the 90s, has aged well throughout this millennium. It has gone from high growth to stable value. From 2011 until today, it has paid consistent and growing dividends… and remains undervalued compared to the rest of the market. Yet performance-wise, few have done better:

csco1-1

There’s no reason this couldn’t continue. But that little bit at the end hints at a unique short-term opportunity.

As you can see when zoomed in on recent trading, that spike since late 2018 is huge.

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It has handily beaten the rest of the market in that period. And while the company is still favored to do well over the long term, no matter who actually wins the technology cold war, this incredible rally is a bit too hot.

For starters, the ongoing trade negotiations actually represent a threat to CSCO. The Huawei situation is most certainly part of the closed-door talks. For easing tariffs and restrictions in other areas, U.S. negotiators could easily agree to relax its posture on the Chinese tech giant.

Then, there’s the actual business of building the 5G network. It is incredibly expensive. And there’s still a lot more work to do. Cisco is eating those costs until it can launch the tech on a larger scale. So, growth should slow, at least in part.

Finally, let’s consider its actual price right now. Overall, it is still attractive, trading at 19 times its earnings. But since it has transitioned from growth to income-paying value, it more often was going for 14-17 times earnings in recent years. This run up in price puts it just above its recent average. It also puts it much higher than other elder hardware tech plays like Intel and IBM.

This all speaks to a near-term cool down for Cisco. Shares should retreat back to the high $40s from the low $50s they are trading at now. This gives us a great short-term contrarian opportunity on CSCO.

Let’s look at a strategy to play it.

A Strategy For Short-Term Bears

A bear put spread is a type of trade that profits off falling stock prices. The way it works is by buying a near-the-money put option and selling a second one with a strike price below the first.

This creates a net debit to the trader’s account, but far less of one than a straight put option would. The sold put’s income offsets the bought put’s cost.

Since the only risk in this type of trade is the cost to get into it, this offsetting cost lowers to trader’s total risk.

The potential profit is found by taking the difference in strike prices and subtracting the cost to enter the trade. You see, as the underlying stock falls in price through the strike price range between the two puts, the bought put goes up in value.

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Source: The Options Industry Council

As you can see, profits are capped, however. The sold put marks a solid ceiling on profits. But with it offsetting the initial cost, the trade off is often worth it. For Cisco, that’s definitely the case.

Let’s look at a specific bear put spread trade on CSCO…

A Specific Trade on CSCO

A trader looking to get in on this short-term potential correction in CSCO, could buy a March 15 $51 put for $0.53 per share and sell a March 15 $50 put for $0.27 per share. That results in a per share cost of $0.26 or a net debit of just $26 since each contract is worth 100 shares.

That’s the total amount at risk here. Just $26 total. To find the profit potential, take the difference in strike prices ($51 – $50 = $1) and subtract this cost ($1 – $0.26 = $0.74). On 100 shares, that’s a potential return of $74 if shares fall below $50.

In other words, if shares do return to the high $40s, as suspected, this trade would return 285% of the amount at risk. That’s a remarkable short-term gain for such a small bet.

It would take a correction of just 2.6% over the next two weeks. Any news related to Huawei, the tech cold war or profit taking at CSCO could easily move it this much in a single afternoon.

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