Schwab’s Surprise Move Just the Start to a Freefall

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While the rest of the market is reeling over the ongoing gridlock in D.C., the U.S.-China trade war and now a serious and unexpected drop in manufacturing outlook, the hardest-hit industry today is brokerage firms.

Charles Schwab (SCHW) announced that it was joining Interactive Brokers in offering commission free trading for stocks and ETFs. It will continue to charge a fee for options, unfortunately. But this move is the financial behemoth’s attempt at combatting the ongoing competition from free services like Robinhood.

This brokerage war over fees doesn’t come as a surprise. But Charles Schwab leading the big four in this new direction is.

Schwab, Fidelity, TD Ameritrade and E*TRADE have all seen the writing on the wall for quite some time. With app-based trading services picking up speed, these “old-school” brokerage firms have been losing market share for the past few years.

To combat it, up until now, they have only been inching down their fees and offering more select ETFs and other funds customers can trade commission free. But still, investors were turning to the likes of Robinhood in the U.S. – and DEGIRO in Europe. Both of these new-age trading platforms offer basically free everything.

This move to join, or at least compete more directly, with these commission-free competitors, has sent the whole traditional brokerage industry reeling today.

As I write, TD Ameritrade is down 24%, E*TRADE is off 17% and Schwab itself is dropping nearly 11%. Fidelity is privately owned. But you can bet its owners are none too pleased.

The idea is that despite everyone knowing this is where things were headed, Schwab’s first-strike to commission-free trading is going to force everyone’s hand sooner-than-expected.

Schwab, however, might have made an extremely smart move despite what it’s done to its industry in the short term. You see, the vast majority of its revenue comes from interest income on its $3.75 trillion in client assets. Of the major players, it will hurt the least from this new move.

E*TRADE derives 17% of its income from commissions. TD Ameritrade gets about one-third of its top line from these fees. Meanwhile, Schwab’s percentage of total revenues attributed to trading fees has fallen from 15% in 2014 to just 8% last year. Meaning it will be hit the least if the whole industry has to give up on charging for stock trades.

Schwab’s move to commission-free stock and ETF trading will force the other major players to do the same. They will either do it quickly and suffer more… or wait and let Schwab steal those customers, which it has proven to successfully upgrade to other products such as its banking and retirement advising offerings.

However, not all is great here. Yes, Schwab might be the winner out of the big four. But just because it will be the least hit financially from this move doesn’t mean it can’t drop farther.

We noted that it derives the vast majority of its revenue from interest income. But that’s not necessarily a great place to find growth. In fact, because of the terrible yields in today’s market, Schwab itself had to recent cut 600 jobs blaming the overall economy and more specifically falling interest rates.

The best it can hope is that this move to cut commissions will attract enough new clients to open accounts that the new money from those deposits will outweigh the falling interest rate environment. Schwab is huge, obviously with $3.75 trillion in client assets. But that doesn’t mean it has many streams of income.

Interest income accounts for more than half of its top line. And that’s the only segment its even seen any growth.

As rates continue to decline and flounder at these decades-low levels, Schwab’s interest income line will continue to suffer.

So, despite today’s 10% decline, a much bigger one is on its way.

The broker announces its next quarter of earnings results in two weeks. As its investors get a good look at its falling numbers and its inevitably disappointing outlook, another shoe will drop.

As you can see, even today’s decline hasn’t sent shares down to where they were just a month and a half ago.

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A drop to the $36 mark is likely this week. But a crash through that support level following its next earnings could send them into a freefall.

Fortunately, there’s a great way to play this situation without betting the farm… or shorting Schwab stock.

A Strategy For Short-Term Bears

A bear put spread offers a perfect way to play falling stock prices in the short term. The way they work is by buying a near-the-money put and selling an out-of-the money one.

The income from the sold put helps offset some of the cost of buying the first one. This reduces the total trade’s cost and therefore the amount at risk.

In exchange, this does cap the potential profit. But unless you think a company like Schwab is going to go to zero – a nearly impossible scenario – than this is a far better risk/reward balance than simply buying puts outright.

Plus, with today’s deep drop, puts have shot up in price. The income from selling one of these is really the only way to even that cost increase out.

You can see how this type of trade works here:


Source: The Options Industry Council

As for which puts and which expiration to target, we turn to Schwab’s historical pricing. As noted, its next support level is $36. But it should blow through that down below $35 with ease after its next earnings in two weeks.

Since we’ll want to leave some time for investors to fully sell off SCHW shares post earnings, we’ll target November for this trade.

Let’s look at a specific example using these criteria…

A Specific Trade on SCHW

Right now, a trader could buy a November 15 $37 put for $1.64 per share and sell a November 15 $35 put for $0.90 per share for a cost of $0.74 per share. Since each option is worth 100 shares of SCHW, that’s a net debit of $74.

That’s the total amount at risk. The only way the trader would lose that would be if SCHW somehow rebounded from here. Considering its path to growth is nearly nonexistent right now and investors are already nervous about its future, that’s unlikely.

Instead, a fall through that $36 support level even past this trade’s $35 target is far likelier.

If that happens, and shares of SCHW continue retreating, this trade will profit. To find out just how much, take the difference in strike prices ($37 – $35 = $2), and subtract the cost ($2 – $0.74 = $1.26). On 100 shares of SCHW, that’s a maximum profit target of $126.

In other words, this trader would be looking at a 170% return on the amount he has at risk. It’s hard to find another way to nearly triple your money on a company so obviously in trouble in the short term.

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