By: Costas Bocelli — October 7, 2021
Taking A Risk On Technology The Smart Way
The Technology sector is getting hit hard in the recent market correction.
That makes sense considering the quick jump in interest rates we’ve seen recently. (Chris Rowe talked about how investors should look at quick interest rates moves in his Technical Tuesday article from earlier this week. That’s a smart read, so check it out if you haven’t already.)
Actually, when it comes to how investors should look at the market, Chris recorded this very candid discussion about the pushback we've been getting for being so straight forward. Click here to watch.
The fastest-growing companies are impacted the most by quick changes in interest rates. And Tech firms are some of the fastest-growing companies out there. I’ll come back to that point shortly.
There are a few other reasons—such as the semiconductor shortage—why Technology is getting hit harder than other sectors.
Just look at the Nasdaq-100 Composite below. As you might know, the Nasdaq is composed of Technology stocks. And as you can see—highlighted in yellow—it’s been down as much as -7.68% recently.
(Click any image to enlarge.)
By comparison, the Dow Jones Industrial Average is down -5.00%. The S&P 500 is down -5.21%.
Understanding Relative Weakness
Here at True Market Insiders, we’re always talking about the importance of relative strength.
But there may be no better example of relative weakness right now than Technology—a major sector that for over ten years has dominated the rest of the market in terms of relative strength.
Look at the US Industry Bell Curve below. This tool is a feature of Sector Prophets Pro, our premium data and sector research platform.
You can see the overall weakness of the market when you notice that 33 sectors out of 45 are in red, signifying that those sectors are in a column of Os on their respective point-and-figure Bullish Percent Index (BPI) charts—supply is in control so it’s a bearish indication.
You’ll also see—outlined in yellow—that Technology sub-sectors such as Software, Semiconductors, and Internet are some of the weakest.
Let’s take a look at the Sector Relative Strength Matrix—another feature of Sector Prophets Pro. In the image below I’m only showing the bottom 10 of the 45 sectors we monitor.
You can see highlighted in yellow that Software is sitting in position 37, Semiconductors is in position 36, and Internet is in position 43.
So these sectors are down right now, but based on longer-term relative strength, they’re far from being out.
So...You’re probably thinking, “Yeah, but…”
And I get it. So if you're thinking about risking even more on tech stocks to take advantage of the recent selloff, let’s just think about it a little more.
How To Trade Smart When Risks Seem High
This is where being smart about your stock holdings is most important. When the market is going down, you have to ask yourself: just how much of your profits on a stock are you willing to give back?
Some of the tech stocks are down much more than the Nasdaq’s -7.68%.
Let’s look at Docusign, Inc. (DOCU) as an example. It was a pandemic darling that shot to the moon. From its March 12, 2020 low of $64.88 to its August 10, 2021 high of $314.76, DOCU was up more than 385%.
But since then, DOCU has been smacked down, and has traded as low as $241.95 recently. That’s a decline of more than -23%.
In the chart below, you see highlighted in yellow the incredible growth of DOCU from the 2020 low to the 2021 high. You can also see the recent selloff to the 200-day simple moving average (SMA) that it’s now using as support.
Do you own DOCU stock or a company like it? Are you tempted to buy more, and double-down? Is your plan to add more risk and more capital?
How about instead we think smarter.
For every 100 shares of DOCU that you own, you could buy one DOCU December 270 Call and Sell 2 DOCU 290 Calls—a 1x2 ratio.
With DOCU trading around $260 right now, the Dec 270 Call is $15.00 and the Dec 290 Calls are $8.00 each. So, the trade can be done for a $1.00 credit. You’re actually getting paid to take this position.
The reason you can sell the second 290 Call without accepting unlimited risk is because you already own 100 shares of DOCU. This 1x2 option combination is what is referred to as a Ratio Spread.
Let me explain further.
What you’re actually doing here It’s buying a Bull Call Spread—that is, you’re buying one December 270 Call and selling one December 290 Call.
Then... you’re selling one more December 290 Call because you already own 100 shares of DOCU to cover it. It’s important that you buy a spread like this all in one ticket order for a $1.00 credit or better.
Here’s the math again. Sell two December 290 Calls for $8.00 each. When you sell something, you collect money. So, you’ve collected $16. You buy the December 270 Call for $15, so you still have a $1 credit left over.
If the stock is at or above 290 at expiration, the entire position will generate a $21 return—$2,100. Your 100 shares of DOCU may be offset by the exercise of the December 290 Calls, but let’s look at the math to compare the returns.
A move back to the DOCU high of $314.76 per share from here at $260 per share, would generate a return of about 21% on a straight stock play.
A move back to the high with this ratio spread strategy would generate a 2,100% return. Since you already own 100 shares of the stock, you accept no additional risk with this trade. You will have made the full $20 between $270 and $290, plus the $1 credit.
That’s the leverage power of options. It makes you whole with just a fraction of the upside move needed.
Interestingly, taking advantage of the power of options doesn't even necessarily mean you have to trade options.
How can you beat that?
Got options? You should.