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Friday, December 14, 2012 - 06:00
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Friday, December 14, 2012 - 06:00
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Friday, December 14, 2012 - 06:00

2 Stocks That Could Suffer When This Trend Ends

Friday, December 14, 2012 - 6:00am

Election years always bring out predictions about which stocks will do best under the next administration. These predictions are usually little more than informed guesses since no one really knows what policies will be implemented until after a president takes office and begins setting an agenda. Speculation about the agenda for the next few years has driven some stocks to irrational prices, and some of them now look ready to fall back to more rational price levels.

After the election in November, gun makers Smith & Wesson Holding Corporation (Nasdaq: SWHC) and Sturm, Ruger & Co. (NYSE: RGR) moved higher. Smith & WessonSmith & Wesson gained 24% in the five weeks after the election and Sturm, Ruger moved up 39% in that time.

These price moves seemed to be fueled in part by rumors that new gun laws were going to be implemented that would make it difficult for anyone to purchase firearms in the future. There do not seem to be any actual laws like that being introduced or discussed as a priority by anyone in Washington, and it looks like the stocks are starting to sell off. It would not be unreasonable to see each stock trade where they were this summer, before the speculation began, or even lower.

Support in Smith & Wesson can be seen near $8, about 18% below the recent price. Sturm, Ruger could find support near $43, about 11% below its recent price. At support levels, both stocks will have set up double-top patterns that point to even more downside. The recent $3 trading range in Smith & Wesson points to an ultimate price target of $5 in that stock. Sturm, Ruger could fall to $28, based on the stock's $15 trading range. In both cases, that would return the stocks to about where they began trading in 2012.

The stochastics indicator for both stocks indicates that the downward trend has probably already begun. Both stocks formed bearish divergences as the prices moved up and last week the stochastics indicator turned bearish for both stocks.

To take advantage of downtrends, traders can sell a stock short and both of these stocks seem like great short opportunities. Many traders prefer to avoid short trades because the risk on these trades is in theory unlimited. Rather than shorting stocks, traders can also use put options to benefit from down moves since put options go up in value when a stock's price falls.

Options are available on both stocks, but they are trading at values that indicate traders expect to see high volatility in the price of the two stocks. In fact, put options do not offer much of a chance for reasonable profits unless the stocks suffer extremely large drops very quickly. As an alternative, traders can sell call options to benefit from a decline.

January $10 call options on Smith & Wesson could be sold for about 55 cents a share and Sturm, Ruger options with an exercise price of $50.50 could be sold for about $1.30. The unusual strike price of $50.50 is the result of a special dividend declared by Sturm, Ruger. If the call options expire below the strike price, then the seller keeps 100% of the premium as profit. If the stock is above that price, then the trader would have to deliver the shares at a loss or close the option trade by buying a call at a loss. Because your risk when selling naked calls is theoretically unlimited, it is important to always use a stop-loss with this strategy.

Selling calls seems like the best way to benefit from overheated gun makers.

Action to Take --> Sell Smith & Wesson Jan 10 Calls for $1 or less. Set stop-loss at $1.50. If Smith & Wesson closes below $10 at expiration, the trade delivers a 100% profit.

Sell Sturm, Ruger Jan $50.50 Calls for $1.50 or less. Set stop-loss at $2. If Sturm, Ruger closes below $50.50 at expiration, the trade delivers a 100% profit. ls for $1.50 or less. Set stop-loss at $2. If Sturm, Ruger closes below $50.50 at expiration, the trade delivers a 100% profit.

This article originally appeared on TradingAuthority.com
2 Stocks Set to Take a Dive When This Wall Street Mania Ends

Michael J. Carr does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.