Over the weekend, IBM announced a monster $34 billion deal to acquire open-source distributor Red Hat. According to IBM CEO Ginni Rometty, this is all about the cloud, estimating it as a $1 trillion industry.
Right now, IBM is in a battle with Alphabet (Google), Amazon, Alibaba, and Microsoft for this business. And it has been losing. According to the Wall Street Journal, IBM controls just less than 2% of current cloud business. So, this deal could be huge.
It is also extremely rare for the company. The sheer size of this acquisition equals the total size of all of its acquisitions over the last 15 years. IBM simply doesn’t make monster deals like this.
Investors are mixed on it, however. They see the price tag of the deal as a bit much, sending shares of IBM down on trading Monday.
Meanwhile, Red Hat’s shares have exploded on the news.
Now, IBM does have other businesses. It’s traditional products – including infrastructure products, security software, and automation – still make up the largest parts of the legacy tech giant’s business. Even with this deal, that won’t change overnight. But it does put more eyes squarely on the company.
Over the last several years, revenue and earnings have fallen consistently at IBM. Sales were $79.1 billion in 2017, down from more than $92.7 billion just a few years earlier.
It’s $12.4 billion in free cash flow is still more than sufficient to cover its dividend and investments. But that has still given some investors concern going forward. Being such a widely held behemoth for its regular quarterly dividends makes this a special area to consider following the deal.
Now, that’s not to say the company is in any real financial trouble. But it does mean there will be continuing speculation surrounding IBM’s stock price for the foreseeable future.
It might remain weak in the near term, at least until this deal moves through the process. As option investors, this gives us a unique chance to cash in some nice income from a company not known for rocking the boat… or offering sizable option opportunities.
Take Advantage of Short-term Weakness With This Strategy
For option investors, short-term weakness in a stock can be a wonderful opportunity to trade in on that volatility. One way to do that is to sell options on companies like IBM.
Selling options on a stock, however, can be quite expensive and risky if you don’t also do something to limit how exposed your trade is.
One strategy that lets you both keep a good amount of the income from selling options and limits your further downside risk is a bear call spread.
This is a type of trade that cashes in on the difference in premium prices by selling one call option and buying another with a higher strike price.
The way it works is you sell a call option with a strike price close to where the underlying stock is currently trading. Simultaneous to this move, you also buy a call option, with the same expiration date but a higher strike price.
This lets you keep the difference in premium as an instant credit. But because you bought protection on any price movement on the upside, you don’t have your whole trade at risk.
Here’s what the risk profile of a trade like this looks like:
Source: The Options Industry Council
What makes this kind of strategy so attractive to stocks like IBM is the known risk/reward. The initial credit when opening this trade is your maximum profit. The risk is also known right from the outset. It is the difference in the exercise prices of the call options you are trading minus the premium you received to open it.
A Bear Call Spread in IBM
We could sell a November 16 $120 call for $2.89 and buy a November 16 $123 call for $1.85. This trade would give you a credit of about $1.04, or $104 per contract since each represents 100 shares.
That $104 per contract is your maximum profit. Your maximum risk would be if shares bounce back up hard. But it is limited by the call you purchased when opening the trade.
With a $3 difference in strike prices, or $300 per contract, you simply subtract your credit to find the risk. In this case, that’s $1.96 or $196 per contract ($123 – $120 = $3; $3 – $1.04 = $1.96).
This brings your total potential return to 53% of the amount risked for holding this trade about four weeks. That represents a sizable return for a relatively low-risk opportunity.
You’ll see the maximum profit on this trade if IBM remains below $120 until November 16. That remains a distinct possibility with the extra scrutiny surrounding the company in these few weeks following the Red Hat announcement.
— The Option Specialist