With political leaders considering changes to taxes and fiscal policy that could have significant economic effects, the market is likely to be driven by irrational fears or hopes. After a deal is reached to avoid the fiscal cliff, or if the talks collapse and the nation plummets over the edge, traders may frantically buy or sell stocks and we could see a volatile move. Rather than try to guess which way things will go, it is important to have some trades that can benefit from either reaction.
Overvalued stocks could offer some protection against the downside risks of the market. These are the kind of stocks that could fall more than average in a market sell-off, or they could fall even if the broad stock market rises because they are overvalued. Buying low-cost put options offers a way to benefit from the potential drop in prices while limiting the risk to a small dollar amount.
United States Steel (NYSE: X) may be one of the most overvalued stocks in the market. The company reported a loss during the past 12 months and earnings per share (EPS) has contracted at an annual rate of more than 35% in the past five years.
Analysts are forecasting annual earnings per share (EPS) growth near 7% in the next five years. However, United States Steel is trading at about 13.7 times next year's expected earnings of $1.60 per share, and analysts have been aggressively lowering their earnings forecasts in the past three months. Only 90 days ago, analysts expected EPS of $2.73 in 2013.
The balance sheet for United States Steel looks as troubled as the income statement. The company has nearly $4 billion in debt and interest payments total about $190 million a year. In the past four quarters, United States Steel reported operating income of less than $100 million. With interest expenses exceeding operating income, United States Steel could be facing further losses in the future if sales slow or expenses rise.
Buyers of put options would see their investments gain if the price of United States Steel falls. Puts expiring in January with an exercise price of $21 are trading for about 88 cents. They would be profitable if United States Steel trades below $20.12, which is about 8% below the price of United States Steel. A move of that size is likely if stocks drop since United States Steel has a history of losing more than the market in declines.
If stock prices fall, it is likely that United States Steel would quickly reach $19 where there is long-term support. There is some initial support near $20.50, and if United States Steel trades at that level, then traders should consider adding to positions.
It seems unlikely that United States Steel will challenge its all-time highs at any time in the next few years. The bigger question for traders is how low the price may go. While waiting to learn the answer to that question, United States Steel can be used as insurance against a market drop.
Action to Take --> Buy United States Steel Jan 21 Puts at $1 or less. Do not use a stop-loss. Set price target at $2 for a potential 100% gain in seven weeks.
This article originally appeared on TradingAuthority.com:
A Bit of Market Insurance Could Make You 100% if Stocks Drop