If you’ve been closely following stocks so far in 2019, you might have picked up on a strange twist. Despite being incredibly negative about guidance, tech companies have done exceptionally well year to date.
The Nasdaq Composite, which is flavored with more tech stocks than either the Dow or S&P 500, has been on a tear this year, up 16%. That compares to just 12% for the S&P and 9.7% for the Dow.
Yet, as noted, individual tech companies are actually quite pessimistic about their prospects in 2019. In fact, according to CNBC, these tech plays haven’t been this negative about a quarter since 2012, seven full years ago.
The reasons range from lower consumer demand and higher inventories to negative currency exchange rates and the ongoing trade wars. But the fact of the matter is, investors haven’t been listening.
Individual tech plays like Apple and AMD have done even better than their peers. Apple is up more than 20% on the year, despite reporting terrible launches for its last few iPhones and dreadful consumer sentiment. AMD is up a remarkable 39% so far in 2019, despite an awful series of financial quarters across the semiconductor market.
So, what’s an investor to do? Can we simply say that this sector is overheated and expect a correction?
Well, it’s not as easy as all that. Just this morning, news of a “softening” of China’s trade stance with the U.S. indicates the two sides might indeed be close to a deal. If that were to happen, tech could continue its wild performance this year.
One of the main problems many in the sector, especially those on the hardware and equipment side, say is the increased cost of materials because of tariffs. In addition, the Chinese economy has started to show signs of a bit of a cool off. A trade deal could instantly make both of those issues better overnight.
So, betting against tech isn’t an easy move either right now.
Instead, we are left with a decision. We know that what tech stocks have done in 2019 isn’t really sustainable. Either they are too hot, or are on the verge of another catalyst to shoot higher. But we just cannot know which direction they’ll take.
Fortunately, for options traders, direction isn’t so important as knowing that they will move.
And there’s no better way to play that than with the Invesco QQQ Trust (QQQ). This ETF holds shares in companies that make up the Nasdaq 100 Index. This index is comprised of the 100 largest non-financial stocks on the Nasdaq.
Basically, this is pretty much a blue chip tech index and ETF. This gives us a clear picture of what the entire sector is up to. Its top holdings include Microsoft, Apple, Intel and Cisco. So, nothing happens in the tech world without QQQ moving.
The way to play it, however, isn’t necessarily obvious… unless you are already a seasoned options trader. But that doesn’t mean it isn’t both simple and lucrative.
Let’s get into a strategy to take advantage of tech’s curious situation.
A Strategy to Play the Tech Sector’s Volatility
A long straddle is a type of options trade that involves buying both a call and a put option. The idea is that no matter which direction the underlying instrument moves, one of these two options will skyrocket in value.
As you can see, it is a strategy that offers near limitless profit potential:
Source: The Options Industry Council
The risk here is straightforward. If shares of the underlying equity don’t move during the duration of the trade, the most money the investor could lose is the amount it cost to enter the trade. When looking at tech stocks of late, it would be hard to argue that they simply won’t move over the next few weeks. Something has to give.
To find the point at which this kind of trade enters profit territory, you simply take the cost of the whole trade and apply it to the strike price of the two options.
So, if the underlying shares of the trade fall, you would subtract the cost of the two puts from the strike price to find your profit threshold. If shares rally, you add the cost to the strike price.
Let’s look at a specific example using QQQ.
A Specific Trade on QQQ’s Uncertain Outlook
Since shares of QQQ are sitting at $179, we’ll use that as our strike price. By option expiration day in April, we should know a lot more about the tech sector’s next move.
If the US and China do reach a deal, shares could rally in a hurry. If not, and those pessimistic corporate forecasts come to fruition, we’ll start to see those effects.
So, a trader with this in mind, could buy an April 18 $179 call on QQQ for $3.23 per share and an April 18 $179 put on QQQ for $3.12 per share for total cost of $6.35 per share. Each contract is for 100 shares of QQQ. So, that makes the total net debit to the trader’s account $635.
That might sound like a lot. But consider how easy this trade would be to turn that risk into a hefty reward.
Remember, no matter which direction the tech sector heads over the next few weeks, this trade could seriously profit. Both possibilities offer near limitless profit potential.
To find the point at which this trade becomes profitable, consider the cost and the strike price. If shares of QQQ fall, they’d have to drop below $172.65 to reach a profit. If shares continue to outperform the rest of the market, they’d have to jump to $185.35 to turn this trade into a profit.
This kind of move isn’t really that farfetched. Consider, QQQ started the year trading at below $155 per share. Over just the last six months, the ETF has traded as low as $143 and as high as $187.50.
With trade talks potentially nearing an end and first quarter earnings season about to reveal the truth of tech’s negative guidance, there’s a large chance such a move is not only possible. It is probable.
— The Option Specialist