It’s a shame whenever an exciting new industry finally gets the attention it deserves only to see long stretches of idleness and forgetfulness follow. But investors are fickle.
Today, that’s exactly what’s happening in cannabis. From last year’s first-half record rally, to the second-half slump, to the miraculous recover in the first few months of 2019… cannabis stocks have been in the financial news a lot.
But we’re seeing a major downtick in the number of headlines, excitement and volume. Take a look at this chart:
This is the past six months or so of trading action at the industry’s largest company, Canopy Growth Capital (CGC)… you know, the one that has an investment deal with Constellation Beverages (Corona).
As you can see, it has been on a rollercoaster. But look at the volume below its stock chart. Post-Canadian legalization, investors and traders alike have slowly turned away from the company. As prices fell with the rest of the industry (mostly from profit taking), volume crashed.
Then, everything turned around. More numbers came out about the enormous demand from Canada – where Canopy and many of the other publicly-traded pot stocks do business – along with the U.S. Farm Bill (which legalized hemp production) made it into law.
Notice the bounce in CGC’s step during the first few weeks of 2019. Investors were again enthralled with the pot industry. But, as with all things in this fickle business, excitement fell off sharply.
We are now in another lull for the industry. Shares haven’t fallen quite so far as last time. But investor participation has.
To anyone with even a tiny bit of common sense can see that this signals something is going to happen. This kind of low volume and sideways performance indicates investor consolidation before a breakout in one direction or the other. This one is no different.
But, unlike most of the rest of the market these days, cannabis is unique in what it offers investors. It is not highly correlated to the overall stock market or economy. It is such a new and high-growth industry that is as diverse as you can imagine.
But it doesn’t really matter what happens next in the trade negotiations with China or if European manufacturing slows down. It isn’t affected by high federal debts or slumping energy prices. Cannabis operates outside of the concerns almost every other type of company deals with.
That makes this consolidation special. It offers investors a unique chance at getting ahead of the next breakout.
As you can see in the above chart, each time investors cooled off and slowed their roll in regards to CGC, its stock price took off afterwards. And with all that’s going on in this industry, we see the same happening this time too.
It’s not as if the company has any real downside pressure. The news has all been extraordinary for the industry leader.
In just the last two weeks alone, the company announced:
- An extended partnership with DNA Genetics (a global company on the forefront of new strains),
- A manufacturing agreement with a British Columbia company for processing of Canopy’s production,
- The acquisition of a US-based hemp company focused in the CBD market,
- A new cultivation license for the production of an additional 5,000 kg of cannabis annually and
- A new brand under which to sell its product that happens to have celebrity ties to Seth Rogan.
That’s just in a two-week period. And that doesn’t include the larger, industry-wide headlines that seem to be missing the mainstream, like legislative progress toward some form of legalization in New Jersey, Virginia and even Texas.
Just today, the crucial House Financial Services Committee cleared a bill that would potentially open up even more banking and financing options to cannabis companies. It is now set for a House-wide vote. Though, to be fair, the Senate’s odds of passing or even voting on it are still slim.
But all of this seems like extremely positive news. Yet shares across the industry have been trending sideways. Smart money would look at all of this and say that now’s a great time to be bullish on the industry again.
Fortunately, there’s a tremendous way to play this short-term consolidation and likely upcoming breakout.
A Strategy For Short Term Bulls
A bull call spread is a type of options trade that involves buying one call option and selling another one with a higher strike price.
This results in a net debit. But it is significantly cheaper than buying just the call option. And it still lets traders harness the leverage stock options offer.
The way it works is to find a play that is likely to breakout to the upside in the short to medium term. Then, a trader would buy a call option with a strike price near the current trading price of the underlying security. And finally, he would then sell a second call option with a higher strike price.
The risk is known up front. It is just the amount it cost the trader to enter the trade. The potential return too is known. It is found by taking the difference between the two strike prices and subtracting the entry cost.
This results in a rather conservative, but lucrative way to bank gains on short term rallies.
You can see how that works here:
Source: The Options Industry Council
Let’s look at a specific trade in CGC…
A Specific Trade For CGC Bulls
Traders looking to get into a bull call spread on CGC to play this likely breakout could buy a May 17 $42.50 call for $3.62 per share and sell a May 17 $47.50 call for $1.73 per share for a net debit of $1.89 per share. On 100 shares, that’s an entry cost of $189.
These traders wouldn’t have a penny more than that at risk for the full duration of this trade, ending on May 17.
To find the potential return, take the difference in strike prices ($47.50 – $42.50 = $5) and subtract that cost ($5 – $1.89 = $3.11). Again, on 100 shares for each contract, that’s $311.
In other words, a trader now could put up $189 in exchange for a very good chance at $311 in return. That’s a return on risk of 165%.
For these potential traders, shares of CGC would have to rise above $47.50. They are currently trading just under $43.
To put this potential rise, consider that just three weeks ago, those shares were above this mark. And the last time we saw this kind of consolidation, shares rallied 94% in just two months. For this full 165% potential return, they’d only need to jump 10.7% over the next seven weeks.
— The Option Specialist