Name That Trade – $WYNN: Catch a Falling Knife Edition

by CC September 25, 2015 12:27 pm • Commentary

On Sept 2nd (Name That Trade – For the $WYNN) we took a look Wynn Resorts when the stock was $72. At the time it was already down 50% from its 2015 highs, down 71% from its 2014 and all time highs near $250, and down 30% in just the last month. We had the following to say:

Your guess is as good as mine where it bottoms. Just like oil it appears that there are some supply / demand elements in Macau gaming that seem out of whack and could take quarters, possibly years to work themselves out.  And just as WYNN overshot to the upside in early 2014, it has the strong potential to do so on the downside.

In 2009 when the stock traded as low as $16, WYNN saw its earnings decline 90% year over year, from $2.51 to 26 cents, despite sales actually increasing 2% from 2008 to 2009 to $3.05 billion.  Since 2009 WYNN saw a dramatic ramp in earnings to $7.58 a share in 2014, but now has an expected 58% decrease in 2015.  The stock trades as if investors think that 2015 estimates are still way to high as the stock trades at 22x expected 2015 earnings.

While we are not yet ready to catch a falling knife, we did offer a way to use elevated options prices to define a wide range where one could have long exposure down at long term support, then down some 30%, while offering leverage to a massive reversal with no initial premium outlay.

Our skepticism as to trying to pick a bottom then was correct, as the stock is down 17% since we penned that post, now down 60% on the year, and down 77% from its all time highs.  As a fairly important point of reference, WYNN shares declined 92% from its 2007 peak to its 2009 trough, before going on its first of two epic rallies before its 2014 peak:

WYNN since 2002 from Bloomberg
WYNN since 2002 from Bloomberg

So after three years of skepticism regarding what we felt was a bubble in Macau expansion we think it makes sense to start to consider a possible turn in the months/ quarters to come. Shares of WYNN collapsed far before this year’s stock market rise and fall in China, and will likely turn well before the economic data stabilizes and the stock market gets its footing back.

Since last week’s acknowledgement by the US Federal Reserve that they are closely monitoring global growth, and resulting risk asset volatility from the lack thereof, we think it makes sense for those looking to make contrarian plays in some of the most toxic trades out there to define ones risk.  For those looking for good risk reward set ups, one could exist with WYNN.

Here is how we would now use elevated options prices in WYNN to finance the purchase of upside calls, playing for a sharp reversal between now and January expiration:

Hypothetical Trade: WYNN ($59.25) Sell Jan16 50/45 Put Spread at $1.20 & Buy Jan16 80 call for $1.20 – Own Put Spread Risk Reversal for even money:

-Sell to open 1 Jan16 50 put at 3.15

-Buy to open 1 Jan16 45 put for 1.95

And use the $1.20 premium received for selling the put spread to:

-Buy to open 1 Jan16 80 call for 1.20

Break-Even on Jan16 expiration:

Profits: above 80, up 33%

Losses: of up to $5 between 50 and 45 with max loss of $5 below 45, down 24%

Rationale:  On a mark to market basis prior to Jan16 expiration this trade structure will show losses as the stock moves closer to the short put strike, and slight gains as the stock moves closer to the long call strike. It’s important to remember that this trade (for the most part) does not have a high probability of profitability as the 80 call has a delta of only 16, so the options market is saying there is only a 16% chance that the call is in the money on Jan16 expiration.  We think that is too low given the stock’s decline over the last 18 months, but as you can see from our choice of trade structure, we are not willing to pay for that 16% chance and we have chosen very wide strikes on the downside as we think there is a decent chance the stock could drop another 10 to 20% between now and Jan16 expiration, which is why we want to define our risk.

While this strategy seems complicated, and possibly risky in a stock like this that is sort of ground zero for the China growth debate, we are defining our risk to just $3.80.

Once again we are not ready to pull the trigger on the trade, but we have slightly changed our mindset in how we would look to express the contrarian view if and when we eventually do. But we thought the explanation would be educational.