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Profit From GM's Recalls With This Income Trade

 May 30, 2014 07:29 PM
 


This is no doubt a tough market to trade. Stocks seem to be levitating over a pit of ravenous bears.

On average, taking big short positions has been a losing proposition for investors, as many stocks have managed to climb higher in the face of uncertainly. If you are going to go short, there better be a darn good reason to do so.

Even though momentum stocks may look overpriced, it's safer to use less volatile stocks in this market environment. Traders should also use stop-loss orders and have realistic expectations.

One stock that I am willing to bet against here is General Motors (NYSE: GM).

[Related -Warren Buffett's Latest Dividend Stock Buys/Sells And His Portfolio - Q1/2014]

The company has been recalling vehicles in large numbers. In December, the automaker recalled 1.5 million cars produced in China to replace a faulty fuel pump bracket.

In January, it recalled 370,000 Chevy Silverado and GMC Sierra pickups to reprogram software that could lead to overheating of exhaust parts and fires. And of course, there was the massive recall of 2.6 million cars for defective ignition switches.

Since January, GM has now recalled more cars than it has sold in all of 2013.

Federal authorities are also investigating if the company committed bankruptcy fraud by hiding the ignition switch defect to prevent liability claims. And then there are the civil lawsuits.

But frankly, the recalls are the last thing I'm worried about. What I find much more concerning is the company's earnings trajectory.

[Related -General Motors Company (GM): Tough Start To 2014 Creates Attractive Entry Point]

GM may look cheap based on its price-to-earnings (P/E) ratio, but earnings have been on the decline with net income falling since 2011.

In 2013, GM's adjusted free cash flow declined to $3.7 billion from $4.3 billion a year ago. Total debt more than doubled to $36.2 billion and the debt-to-capitalization ratio increased to 45.9% at the end of 2013 from 30.7% at the end of 2012.

Another bearish sign is that hedge fund manager David Einhorn was reported to have cut his stake in the company in the past quarter. I'd expect the remainder of 2014 to bring more challenges for GM.

While I expect the company will eventually emerge from its recent struggles, the stock is likely to move lower before it recovers and challenges last year's highs.

The technicals support my bearish thesis. The series of lower highs and lower lows over the past several months is indicative of a bearish trend.

GM recently dropped below its 200-day moving average, in addition to a death cross on the chart, which occurs when the 50-day crosses below the 200-day.

The 10-, 20- and 50-day averages are all above the current stock price, which should help add a little resistance in the near term.

Today, I am interested in buying GM Dec 38 puts for a limit price of $5.80.

Source: TradeMonster

I selected the December expiration because I wanted to give the trade plenty of time to work out and cover at least two earnings reports, which may be catalysts to push the stock lower.

This put option has a delta of 75, which means it will move roughly $0.75 for every dollar that GM moves, but it costs about a sixth as much as the stock.

The trade breaks even on expiration at $32.20 ($38 strike price minus $5.80 options premium), which is 5% below current prices.

My first target for GM is the June 2013 low of $31.13, and the second is $29.50, which is also a technical level established last year.

For our stop-loss, we will exit our trade if GM climbs back above its 200-day moving average, which is currently at $36.55.

Action to Take -->

-- Buy GM Dec 38 Puts at $5.80 or less

-- Trigger stop-loss if GM goes above its 200-day simple moving average

-- Set initial price target at $7 for a potential 21% gain in two to four months

-- Set secondary price target at $8 for a potential 38% gain in two to four months

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