A Bullish Trade on the Union of Beer and Pot

With so much going on right now, it’s easy to lose focus of the bigger picture. 2018 has been a wild ride for all stocks. But no group moved quite as high and then quite as low as new-to-the-forefront cannabis stocks.

Pot stocks are viewed as either great ways to get into a fast-growing industry ripe for big profits… or as a fad and are too risky to bet on. The truth is… they are both.

Some companies will continue to grow as the use of marijuana — either for medicinal reasons or for recreation — becomes increasingly legal around the world.

2018 saw the largest country yet legalize cannabis across the board: Canada. But it isn’t alone. Mexican federal courts are working the issue through the system and could have it legalized in coming months. Israel just approved the export of medical marijuana. And Thailand just legalized it.

For those in the deep in with this new industry, there are exciting developments every single day. There are far too many court cases, pending bills and policy changes to keep up with around the world surrounding this industry. But the clear direction all of it is heading is toward universal legalization… at least as much as the alcohol industry enjoys.

Speaking of which, this is another area that lets one differentiate the two types of pot stocks in the market. You have those that are indeed flashes in the pan, with great ideas, shiny investor presentations and big goals. But ultimately, many will be left behind by larger competitors… as is the case in all new industries. Then you have the premier plays.

To reach this status, simply look at who is backing them. The first to emerge last year as a top stock was Canopy Growth Capital, an Ontario-based cannabis conglomerate. It has its hand in just about every pot pie there is. It grows, funds medical research and distributes cannabis across the country. Last year, it hit mainstream sightlines when Corona beer maker Constellation Brands Inc. (NYSE:STZ) invested $4 billion in Canopy.

This was the first and still the largest of these kinds of deals… despite others coming along since like cigarette maker Altria’s $1.8 billion bet on Cronos Group.

The Constellation investment was just the start. You see, beverage companies haven’t been doing so well, compared to their historical norms. Anheuser-Busch InBev, maker of Budweiser and Stella Artois, has seen its bottom line remain flat to slightly lower since its big merger a few years back. The same is true of Molson Coors Brewing over the last two years.

Constellation, however, has been growing each and every year like clockwork for more than half a decade. That is, after all, why it had the resources to invest so heavily in Canopy in the first place.

This partnership is important in the long run for further growth. But it also presents a tremendous short-term opportunity for traders willing to take a chance.

The Beginning of the Cannabis Era

While the deal between Canopy and Constellation has been in the works for many months, Constellation’s next earnings announcement will cover the first quarter in which the partnership finalized and Canada legalized marijuana. You can bet that the two companies have been busy of late.

And guess what? The earnings call comes in less than two weeks’ time, before many of the larger stocks in the market report. That means all eyes will be on Constellation just as the wild late December volatility settles down and (hopefully) some agreements between either the President and Democrats or the President and China are made.

Fortunately, this is one type of trade that has very little to do with the overall economy, however. Constellation certainly does make more money from its traditional business when consumers have more capital. But let’s be real. It is a beer company with a huge cannabis investment. These might be two of the most recession-safe plays you could find. And this quarter is the first time they’ll be official combined in one earnings announcement.

The date is January 9 before the market opens for Constellation’s release. While the company’s stock might move in the current drastic rollercoaster spasms of the rest of the market until then… it’s set to steer its own course from that date through the month as investors make their determination over cannabis in 2019 and what Constellation’s numbers mean for the partnership.

Speaking of how Constellation has been trading as to compare where it should be trading, its recent stock price history is just plain wrong. Despite growing its top and bottom lines each quarter this year and smashing earnings estimates at every turn, this is what investors have done with its share price:

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Again, none of this decline had anything to do with what was actually happening at Constellation. The company was outperforming even those that study it closely. But it fell into the market’s decline anyway.

But as we noted, for a small window next month, that will change. Investors will be forced to take a look at exactly what’s going on with this alcohol-cannabis hybrid. And that means its stock should enjoy great short-term strength soon.



A Strategy For Short-Term Strength

Traders have three options for playing a stock they believe will go up in the short term. First, they can simply buy it. That’s the simplest, but it also puts them in all the way. Buying shares of Constellation for instance, cost $160 each. So, even if shares rise to $170 after the earnings announcement next month, that’s just a $10 return on $160 invested for being right.

Alternatively, bullish traders can buy a call option. This is a sensible approach, in that it costs far less to invest depending on the number of shares they’d otherwise purchase, and the profit opportunity is limitless. But less to invest is still a lot. Right now, a single call option contract for January 18, 2019 at $160 goes for $841. That’s quite a bit for an investment that might not pay out a single dime.

Finally, there’s the third option: a bull call spread. The way this type of trade works is by buying a call option on the stock a trader likes in the short term… and then selling a second call on it with a higher strike price.

The premium the trader receives from the second call hedges the amount paid on the first. Yes, this limits the total profit potential on the trade. But it significantly reduces the amount at risk throughout the trade.

You can see how this trade plays out here:

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Source: The Options Industry Council

Let’s look at a real example of this type of trade for STZ.



A Specific Trade For STZ

A January 18 expiration date for an STZ trade makes the most sense. Its earnings call comes nine days earlier… and any later of a date and it might start reverting to how the rest of the market is trading.

So, a trader could buy a December 18 $160 call on STZ for $8.41 per share and sell a December 18 $162.50 call for $6.86 per share for a cost of $1.55 per share. Since each contract covers 100 shares of STZ, that’s a net debit of $155. Isn’t that better than $841 for a single call option or $160 for just one share that might net him $10 if he’s lucky?

That $155 is the total risk a trader using this strategy has to lose. That would happen if shares just don’t move or slide lower. Like we said, a lot can happen with STZ… but there’s plenty to like for the short term.

To find the maximum profit potential of this trade, take the difference in strike prices of the two calls ($162.50 – $160 = $2.50) and subtract the cost to enter the trade ($2.50 – $1.55 = $0.95). Then simply multiply by the 100 shares ($0.95 x 100 shares = $95).

This works out to a total return of 61.3% of the total risk of this trade. That’s a lot better than what a single share of Constellation would likely bring even if you’re right. And it certainly costs less than simply buying a call outright.

— The Option Specialist

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About the Author: The Option Specialist