134% Profit With This Contrarian Play

The way we watch TV has changed so much over the last few years, there are shockwaves rippling through several related industries: media, technology and communications.

Most people don’t make a call to the local cable provider a top priority when they move anymore. Many people don’t even use a cable or satellite subscription service anymore.

These days, it’s all about streaming services. The fight between Netflix and Hulu is now expanding to include several others like Amazon Prime Video, CBS, ABC and HBO… to name a few.

But one thing that is definite about this rapid change is that it is going to continue. Streaming isn’t going anywhere, but the winners aren’t yet known. That makes companies like Roku so interesting.



You see, Roku doesn’t necessarily need to win anything. It does have its own streaming “channel.” But it doesn’t make the majority of its money from that. Instead, it offers a platform to stream all of those other “channels.” And it is also a leader in smart TVs that use that platform.

If you’re unfamiliar, the way it works starts here:

roku1.png

A consumer decides to “cut his cable” and leave Comcast or Time Warner. With Netflix, Amazon and Hulu subscriptions in hand, he needs to find a way to easily stream each of them on his TV.

That’s where Roku comes in. It offers smart TVs and tabletop boxes that have an operating system… like a computer or smart phone. In much the way Alphabet (Google) has to come to dominate the smart phone OS market with Android, Roku has an industry-leading smart TV OS.

When a customer uses Roku, he is just a click away from all of his streaming accounts. In today’s market, that’s quite valuable. In fact, the company now claims to be the OS of choice in 1 out of every 5 US households.

Roku makes money on advertising, deals with streaming services and smart TV purchases. And that seems to be paying off for the relatively small industry leader.

The company announced its 2018 financial results last night. And they blew away all expectations.

Revenue surpassed not only analyst expectations… but the company’s own projections. Coming in at $275.7 million for the fourth quarter, Roku’s top line grew 46% year over year. That’s an incredible growth rate for a company that’s been somewhat under the radar.

It also locked in 5 cents per share during the quarter… nearly double what analysts estimated. Positive earnings are still a rarity for this small company.

You can see just how excited investors have been to read these results:

As you can see, it has already put together a good year so far. But just today, shares of ROKU are up more than 20%.

Its outlook for 2019 and beyond is even more impressive. It expects this performance to continue and even increase in 2020 and 2021 as it will finally begin making its mark on international markets. Right now, it doesn’t have much overseas business, despite being in 20 outside markets.

It is going to spend a fortune to grow that lucrative portion of its business. And that’s also why investors should take these results with a grain of salt.

No one is disputing that ROKU’s future is bright. The company continues to chug along and grow its U.S. market. But its current transition in focus to international could put a bit of a damper on its nearer-term success.

One analyst, Michael Pachter at Wedbush responded to these fantastic quarterly results with a downgrade because of this argument. He notes that the company is on the right track and is doing all the right things. But he’s worried that its spending is starting to get out of hand while it tries to break into different geographic segments.

Pachter said, “we lowered our long-term EPS estimate on a lower operating margin assumption given a greater likelihood of higher spending levels than we previously modeled.” He went on to add that the company “is spending handsomely to expand its international presence.”

That’s Wall Street speak for: “The company is spending more than we’d like to get this done. And that’s going to hurt the bottom line.” We agree.

None of this is to say that ROKU shares won’t continue rising eventually. But we, like Pachter, don’t think they will continue to perform as they have in the short term. The company itself noted that none of this extra spending to break into international markets will have any impact until 2020 at the earliest.

So, this gives us a short-term opportunity to play the cool off period after this exciting earnings report. Shares should come back down from their recent flight higher. And with the right strategy, traders can play that short-term retreat.

A Contrarian Strategy to Play ROKU’s Excellent Quarter

A bear put strategy lets traders profit off falling stock prices, without as much risk as alternative bearish methods. Unlike shorting a stock or outright buying a put, a bear put trade comes with a much smaller price tag.

The way this strategy works is by buying a put option on a stock you believe will fall in price and then selling a second put option on it with a lower strike price. Some of the cost of the first put will be offset by the premium received from the second one.

This does two things. It first reduces the amount of capital you have at risk for this trade. But it also caps how much you can make on it. As with anything, there’s risk-reward you have to consider.

You can see what that looks like here:

bearputspread

Source: The Options Industry Council



But in the case of ROKU, this particular risk vs. reward tradeoff favors this strategy. Let’s look at a specific example to show you what we mean…

A Specific Trade on ROKU

A trader looking to use a bear put spread trade on Roku could buy an April 18 $65 put for $6.70 per share and sell an April 18 $55 put for $2.42 per share for a net debit of $4.28. Since each contract is worth 100 shares of ROKU, that’s an entry price of $428.

Now, we know that might sound like a lot. But as noted, this comes with a higher reward than potential risk.

First of all, shares would only have to fall to $60.72 for this trade to become profitable. Right now, they are trading at $62.80. So, for a stock that is up more than $11 just today, that small of a retreat is definitely on the table.

And of course, the ultimate reward if shares really do come back to where they likely should be trading is certainly high enough to justify this entry cost.

To find this trade’s maximum potential return, take the difference in strike prices ($65 – $55 = $10) and subtract the entry cost ($10 – $4.28 = $5.72). On 100 shares, that’s a potential return of $572. In other words, that’s a potential return of 134% on the amount at risk.

The likelihood of the trader collecting this full return is actually high too. Investors have two months before this trade expires to decide that today’s manic buying was a bit too much. If shares fall to where they were before today’s trade (which would still leave them up substantially on the year), this trade will max out.

Meaning, if investors realize at any point in the next two months that they can’t expect the same extraordinary results that they did yesterday, this trade could give the trader a sizable $572 return for his effort.

— The Option Specialist

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About the Author: The Option Specialist