The market is overvalued and most near-term catalysts are bearish. Last week, I told you we could be weeks away from a 10%-plus correction. But there's an easy way to profit when the correction arrives.
The secret is buying puts. It's a type of option that goes up in value when the underlying security drops. Some of the best opportunities I'm seeing right now involve buying puts on stocks likely to be hit the hardest in a correction.
High earnings multiples, slowing growth and a cyclical business model are all traits that make a stock especially susceptible to corrections. To that end, there is one popular stock in particular that's looking frothy and ripe for a pullback. The best part is that no one seems to see it that way... yet.
You may be familiar with Keurig Green Mountain (NASDAQ: GMCR) and may even own one of its products. Keurig produces and sells single-serving countertop coffee brewers and beverage makers. Keurig also sells K-Cups -- individual servings of coffee and tea that can be brewed with its beverage makers -- using its own blends as well as products offered through partnerships.
As a cyclical stock, GMCR is highly dependent on consumer health and spending habits. Recent data suggests this could be a problem. Despite low fuel prices, consumer spending saw its biggest decline since 2009 during December, perhaps foretelling weakness in 2015.
What I found particularly concerning was that a 4.3% bump in 2014 consumer spending -- the best since 2006 -- didn't translate into record sales or earnings for Keurig. Actually, quite the opposite.
In its latest earnings report, released on Feb. 4, the company missed estimates and showed an 8% year-over-year decline in profits. The release of its new, highly touted Keurig 2.0 machines didn't do much to motivate purchases, as the company saw an 18% drop in overall brewer and accessory sales.
Management also reduced its upcoming sales growth estimates for fiscal 2015 to mid-to-high single digits, down from high-single to low-double digits previously.
If GMCR sales faltered when consumer spending was near record levels, what will happen when consumers here and abroad start cutting back? We are nearly 70 months into a recovery, well past the National Bureau of Economic Research's (NBER) average economic expansion time of 58.4 months.
Against this background, GMCR looks expensive. Its forward price-to-earnings (P/E) multiple is near 30, which is almost double the S&P 500's multiple of 18. What's even more concerning is that the current multiple is close to a three-year high and comes at a time when analysts have been reducing estimates. In the past 30 days alone, they have dropped their EPS estimate 11% for the current quarter and 3% for the current year.
There are certainly times when you can justify a high P/E for a growth company, but not when earnings and revenue growth are fading.
When investors take off their rose-colored glasses, they revert to more traditional measurements of value, such as industry averages and P/E multiples. As Keurig matures as a company, its growth expectations will moderate, and so will valuations.
The average forward P/E of GMCR over the past three years is 22.1. Even though I believe that's generous, I'd rather err on the side of caution and use it as my forward multiplier into 2016.
If we take 2016 adjusted earnings expectations of $4.75 per share -- which assumes the company turns things around and delivers on growth -- and multiply that by 22.1, we have a fair, conservative value of $105 for GMCR.
That's a nearly 17% haircut from current prices, but we can generate 67% from that move using my profit amplifying strategy.
Adding to my bearish thesis is GMCR's beta. A stock's beta tells us how much it typically moves compared to an index such as the S&P 500. GMCR's beta of 2 means it tends to move twice as much as the S&P 500. So if there is a correction, we can expect shares to fall at least twice as much.
Using options, we can amplify GMCR's potential 17% move into an 67% gain. Specifically, I recommend buying GMCR Jun 145 Puts for $24 or less.
This put option has a delta of 72, which means it will move roughly $0.72 for every dollar that GMCR moves, but it costs a fraction of the price of the stock.
The trade breaks even at $121 ($145 strike price minus $24 options premium), which is 4% below current prices.
If GMCR hits my $105 price target, the call options will be worth at least $40 ($145 strike price minus $105 stock target). Once you enter the trade, place a good 'til cancelled (GTC) order to sell your calls at that price.
Profit Amplifying Trade Setup:
-- Buy GMCR Jun 145 Puts at $24 or less
-- Set stop-loss at $10
-- Set price target at $40 for a potential 67% gain in 102 days or less
I recently sat down with Profitable Trading's publisher, Frank Bermea, to detail how my options strategy works. It's the same strategy that allowed me to retire from Wall Street at the age of 23. Click here to watch it now.
This article originally appeared on ProfitableTrading.com: How I Plan to Make Huge Gains, Even if the Market Crashes