When a company misses earnings or lowers their revenue forecasts, the stock price tends to fall. Some traders invariably "buy the dip," meaning that they buy after a decline thinking the pullback in price is simply a blip in the longer-term uptrend. This rarely works, and usually the first bit of bad news is followed by more bad news and even lower prices.
Netflix (Nasdaq: NFLX) is an example of how bad news can impact a stock's price.
NFLX sits over 80% below its all-time high more than a year after the bad news started to flow. While hopeful buyers averaged down, the stock fell for months before it became oversold. Oversold is shown in the chart with the stochastics indicator. That indicator works well to show how markets reach extreme levels and tend to stay there for extended periods of time.
This insight sets up a trade now in another former high-flyer, O'Reilly Automotive (Nasdaq: ORLY).
ORLY was a market leader after the March 2009 bottom in stocks, soaring more than 430% before peaking in May of this year. In late June, the company warned investors that sales growth was slowing and the stock dropped. The chart pattern suggests the stock will be, at best, dead money for at least a few months.
Even after the steep drop, at the recent price of about $82, ORLY is trading with a price-to-earnings (P/E) ratio of about 19, while the market average is 14. Based on next year's estimated earnings, ORLY has a P/E ratio of about 15. This ratio represents fair value for a stock that is expected to average earnings growth of about 15% in the next year.
In ORLY we have a stock that is trading at a price that can be considered its fair value with the earnings growth rate slowing sharply when compared to the past five years. No matter how optimistic dip buyers may be, it seems like ORLY is no longer likely to be a market leader.
At its current price, ORLY is not really overvalued or undervalued. It is still a great company, but there doesn't seem to be a compelling argument to either buy or short the stock. The stochastics has fallen to the edge of the oversold level and will probably spend some time in the oversold territory before ORLY turns up again. This is the chart of a stock that will probably take a while to build a base and trade within a narrow range for some time.
In the next few months, a small price move in ORLY is the most likely trading scenario. Or, if the earnings report scheduled for October comes in below the estimated earnings, ORLY could fall sharply again. That means it could be profitable to sell calls against the stock to create income.
The November $85 call is trading at about $3.10. If the stock is below $88.10 when the option expires in November, traders will realize a profit from selling this call. If the stock moves above that price, the risk can be limited by closing the trade with a loss.
Selling calls can be a great strategy in stocks that are falling or trendless. This trade offers a potential gain of about 13% during the next two months for a fully margined position. On an annualized basis, this type of return can be a very profitable.
Action to Take --> Sell ORLY Nov 85 Calls between $2.25 and $3.25. Set stop-loss at $4. The call is expected to expire worthless and the premium received will be 100% profit if that happens
This article originally appeared on TradingAuthority.com:
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