“There are decades where nothing happens; and there are weeks where decades happen.”
This week saw the House of Representatives flip to Democrats, the firing of Jeff Sessions, a mass shooting in L.A., and fires spread throughout California. Lenin sure had his share of wild weeks. But every week we are experiencing feels like decades too.
So, when General Electric – one of the world’s oldest and most well-established companies – falls 21.6% from peak to trough in just one week, it shouldn’t come as a surprise.
The company is certainly in a slide. In fact, this week’s move feels a bit too similar to GE’s 2008-09. That was the last time its stock fell below $10 per share. But back then, GE had Warren Buffett come in to bail it out. We’re not so sure that’ll be the case this time around.
But even if that were to happen, one thing is for certain: General Electric’s stock is going to keep on dancing for weeks to come. And for shareholders, those weeks will almost definitely feel like decades.
The company has been struggling for quite a while, to tell the whole truth. It didn’t just collapse overnight. For years now, CEOs Jeffrey Immelt and now John Flannery have been trying to remove the lasting wound their predecessor Jack Welch left them with that is GE Capital.
This division was the GE’s major weakness during the Great Recession, when everything was falling and anything tied to finance fell even harder. But even though they’ve had a decade since then, no CEO has been able to completely remove that burden from GE’s shoulders.
That’s not the only dead weight for these luckless CEOs to deal with. The company’s other businesses have been in trouble too.
Its oil and gas enterprises have cratered. Its healthcare segment is too burdensome (hence spinoff plans). And its transportation arm is faltering too (despite the moves made by Immelt in that department).
All of this has left GE with massive debt, weak to no growth to pay for any of it and demanding shareholders. Its only move left was to cut back its dividend to pay for all of these problems. That was certainly the sensible move, but it definitely didn’t make anyone happy.
Now, could things turn around? Will this extra cash from cutting its dividend help GE refocus on profitable segments? Possibly… even probably. But that’s not where we’d want to put our money just yet. It could take years for any of this to pay out and for GE to recover to its former glory.
Instead, we’re looking at how this impacts the company’s stock right now. And it does leave many options – literally – on the table.
GE Has Been Here Before
Option premiums are determined by price, time and volatility. Price and time are rather straightforward, if you are looking at an option with a strike price that is “in the money” it means that particular option is exercisable. So there is a definitive amount to be gained for the option buyer to exercise his contract. Time too makes sense. The longer out an option contract is, the better chance the underlying stock will be able to move in the direction of the option’s strike price.
Volatility, however, is another game entirely. For some extremely stable companies with low volatility, their options trade at very low premiums. GE used to be one of these kinds of stocks. With the recent move to sub-$10 in such a short amount of time, that is no longer the case.
So, when one is looking to buy options – either calls or puts – on GE now, they have to weigh the extra price to get into that trade. Fortunately, in this case, this calculation favors the buyer.
You see, the last time GE fell this hard, this fast, it proved it wasn’t going to stay this low long. From Feb. 9, 2009 to Mar. 5, 2009, shares of GE fell from $12.64 all the way to $6.66. Remember, this was at the height of the Great Recession. That move represents a 47.3% freefall in less than a month.
From there, however, it didn’t take long before the situation changed yet again. By Apr. 6, GE was trading back up at $11.19, 68% higher than its bottom.
While we can’t exactly expect the same kind of reaction this time, we do know that investors in this sacred historical stock don’t sit on their hands when their stock is in freefall mode.
So, even though premiums for GE options are higher than normal, they are justifiably still attractive to those looking to buy.
Of course, we simply don’t know if GE will recover like last time or continue to fall. Fortunately, there’s a strategy for that.
A Strategy to Profit From Major Moves in Either Direction
A long strangle is an option trade that involves purchasing two contracts — one out-of-the-money call and one out-of-the-money put.
The purpose of this kind of trade is to profit from major price movements in either direction. For a company like GE, it wouldn’t take much for this to become a profitable strategy.
The risk of this kind of trade is the amount to enter it. Since someone entering a long strangle is purchasing two option contracts, the premiums paid for those contracts is the total risk.
The possible profit from this strategy is unlimited. The only problem is that it takes a decent-sized movement in the underlying stock before it does enter profit territory.
You can see how this trade works in this graph:
Source: The Options Industry Council
Let’s look at a specific strangle on GE options right now.
A Specific Strangle Trade on GE
If you purchase a December 21 $9 call for $0.38 per share and a December 21 $8 put for $0.47 per share, you’d spend $0.85 per share to enter a strangle trade. Since each contract is worth 100 shares, that’s a total cost of $85.
That’s your total risk for this trade. You can’t lose more than that (plus commissions) if GE just doesn’t move from where it’s at… an unlikely scenario.
As we noted, your profit is unlimited with this kind of trade. If GE continues its freefall, your put would become increasingly profitable. The same is true with your call if GE recovers like it did in ’09.
To find out the exact point at which it becomes profitable is simple math.
If GE falls from here, it will have to sink far enough to pass your put’s strike price and the premium you paid to get into the trade. That works out to a profit point of $7.15 per share ($8 strike price – $0.85 premiums paid). If GE recovers, this trade becomes profitable at $9.85 per share ($9 strike price + $0.85 premiums paid).
Right now, with GE trading at $8.45, that $0.85 in total premiums represent 10% of GE’s share price. This company has been in trouble before. It recovered quickly back then. If it does again, this trade will bring a profit. If it doesn’t recover this time, a continued fall would still make this trade profitable.
— The Option Specialist