from the desk of Dr. Terry F Allen

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Hard Disk Dive

Storage-device maker Western Digital (WDC) reported earnings on Friday that topped estimates on both the top and bottom lines. However, both measures fell short of the year-ago figures. More importantly, the company issued dismal guidance, blaming softer consumer spending and inventory corrections. Q1 revenue is now expected in the $3.6-3.8 billion range, far below the $4.74 billion consensus estimate. Earnings per share looks even worse, with an expected range of $0.35-0.65 compared to the $1.96 consensus.

Oddly, there were no target price changes for the stock on Friday. However, given that analysts are strongly bullish toward WDC and have a median target price of $65 (38% above Friday’s close), the weak guidance is sure to bring some price cuts, if not outright downgrades.

The stock reacted appropriately after the news, falling nearly 10% before closing 5% lower. This put an abrupt halt to WDC’s monthlong rally that saw the stock gain 20%. The 50-day moving average also marked a top to the uptrend. Friday’s fall also pulled the shares below their 20-day moving average, a trendline that has guided the past three weeks of the rally. Note that the short call strike of our credit spread sits on the 50-day, which will move below the 50 level this week. Thus, the stock will have to pierce both the 50-day (blue line) and 20-day (red line) moving averages to move the spread into the money.

If you agree that WDC’s rally is over, consider the following trade that relies on the stock staying below $50 (green line) through expiration in six weeks:

Buy to Open the WDC 16Sep 52.5 call (WDC220916C52.5)
Sell to Open the WDC 16Sep 50 call (WDC220916C50) for a credit of $0.60 (selling a vertical)

This credit is $0.04 less than the mid-point price of the spread at Friday’s $47.09 close. Unless WDC drops quickly, you should be able to get close to that price.

The commission on this trade should be no more than $1.30 per spread. Each spread would then yield $58.70. This trade reduces your buying power by $250, making your net investment $191.30 per spread ($250 – $58.70). If WDC closes below $50 on September 16, both options will expire worthless and your return on the spread would be 31% ($58.70/$191.30). 

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