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This Apple Competitor Could Make You 118%

 November 09, 2012 04:47 PM

The story of David and Goliath has captured imaginations for thousands of years. But many traders who look for giant slayers among the smallest companies are met with disappointment. Occasionally, however, there are stories of small-cap companies that take on giants and win, and today we have a company that reported $39,000 in revenue during the past 12 months scoring a victory against Apple (Nasdaq: AAPL), a company with more than $150 billion in sales.

On a day when the Dow plummeted hundreds of points, VirnetX Holding Corp. (NYSE: VHC) was up 25%, as of this writing, after a federal jury awarded the company $368 million from Apple in a patent infringement case for virtual private network technology.

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Lawsuits regarding patents have become big business, but they seem to be a source of legal confusion, as well, with courts issuing conflicting opinions. Apple and Google (Nasdaq: GOOG) are at the center of the storm and are aggressively pushing the courts to develop a uniform policy. It seems likely that smaller companies will either have to settle for less than the jury awards or accept years of appeals that could drag their case to the U.S. Supreme Court.

Apple has more than $100 billion in cash on its balance sheet and needs to vigorously defend itself against the claims of smaller companies, so it is very likely to file an appeal.

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VirnetX has been volatile recently as traders took positions in anticipation of the jury's verdict. The stock declined 50% in July, and then consolidated during the past three months. An upside breakout from the consolidation range seems unlikely to hold.

In some cases, traders can overreact to good news about a small-cap stock and push prices up too high. When they realize the short-term gain may be all they will see for a time, they tend to take profits quickly.

If this happens with VirnetX, the stock would be expected to fall back toward the middle of its trading range, which formed mostly between about $26.92 and $23.33. The midpoint of that range, $25.13, is the initial expected downside price target.

VirnetX had miniscule revenue and no earnings during the past 12 months. According to SEC filings, the company has more than 51 million shares of stock issued and outstanding. That means the full value of the jury award amounts to about $7.22 per share, before attorney fees and other expenses. Without revenue and earnings, the payments from patent lawsuits, settlements and royalties will need to be substantial to support a stock price of more than $30 a share.

The rapid gains seen after the recent court decision may prove to be irrationally exuberant, and a price decline could follow. Put options represent the safest way to profit from a potential sell-off. While a short sale is possible, insiders hold large positions, which limit the number of shares available to borrow for short trades. This could lead to high costs for shorts, and there is unlimited risk if a short squeeze develops. A put option limits the risk to the amount paid for the options contract.

Options expiring in December should allow time for traders to react to Apple's seemingly inevitable appeal of the judgment. Puts with a strike price of $30 are trading for about $2.23 and would be profitable if VirnetX falls below $27.77. If VirnetX reaches the downside target of $25.13, these puts would have an intrinsic value of $4.87, and would deliver a gain of at least 118%.

While VirnetX certainly received good news, it seems to have pushed the price up too high and created a profitable opportunity for traders.

Action to Take --> Buy VirnetX Dec 30 Puts at $3.25 or less. Set stop-loss at $2.25, risking $100 or less per contract. Set initial price target at $4.87 for a potential 50%-plus gain in six weeks.

This article originally appeared on TradingAuthority.com:

The Little Stock That's Taking on Apple Could Make You 118%

-- Amber Hestla-Barnhart

Amber Hestla-Barnhart does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.


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