“Buckle your seatbelt, Dorothy, because Kansas… is going bye-bye.” ~Cypher – The Matrix

We’re in a different world now that the SEC has announced its lawsuit against Goldman.  I mentioned over the weekend that I didn’t expect the market to trade down immediately, but over the next few weeks and months we should see a dramatic change in the leadership on Wall Street – and in the premium prices investors are willing to pay for growth.

Monday’s market action was very interesting in that the blue chip indices (Dow and S&P 500) both traded higher, while more speculative indices (Nasdaq, Russell 2000, Small caps) actually lost more ground.  It looks like managers may still be willing to prop up the bull market, but they certainly want to be owning stocks they can justify from a quality basis rather than spinning a yarn about the future growth prospects.

If this “flight to quality” trend picks up speed, we could see a huge drop in small cap prices – especially the names with large multiples and optimistic but very subjective future earnings growth.  The short opportunities could be tremendous as investors deal with the compounding effect of lower earnings projections and lower price multiples.

Consider a company expected to earn $2.00 per share in 2010 and trading with a forward multiple of 30 (the stock price would fall at $60.00).  If analysts decreased their earnings projections by just 20%, and the market took 20% of the premium multiple off the price, the result would be a decline of 36% ($2.00 estimates would drop to $1.60 and the multiple would drop from 30 to 24).  For more speculative vehicles, the decline could be even more pronounced.

VMWare Reports After the Close

The cloud computing industry is one of the more speculative areas of the market with analysts expecting robust growth, and stock multiples trading at levels that would require excessive growth to justify.  VMWare Inc. (VMW) is currently trading above $55 despite the fact that the company is only expected to earn $1.19 per share in 2010 and $1.39 in 2011.  The company’s technology is tremendous…  But the price on the stock assumes that analysts are dead wrong and the company will grow earnings by a much higher rate.

As with any market or economic call, there is always a chance that an assumption will be proven false.  VMW may in fact grow by leaps and bounds over the coming year.  A technology upgrade cycle could lead to a broader customer base, and even a difficult economic period could cause more customers to use VMW’s services to cut costs and grow efficiency.

But the problem is that the stock price is already pricing these positive outcomes in.  What appears to be missing is the opportunity for competitors to eat into market share, for new technologies to make VMW obsolete (or at least a bit less competitive), for capital expenditures to eat into profit margins and disappoint short-term holders…  When stocks trade at these levels, the risk is tremendous and the chance of outsized positive returns become less likely.

VMWare reports after the close today and the stock is currently up 32% on the year.  Regardless of what the company says in the report, I expect the stock to have a muted or even negative reaction.  Think about it – If management says “everything is great and we’re expecting strong growth in 2010,” the stock has already assumed this is true…  The likelihood of a further advance is modest at best.  However, if management says “We’ve had a great quarter and our backlog is at the same level it was last quarter,” investors will likely be disappointed.  The odds seem stacked against the holder of this stock heading into the report.

Handicapping the Report

Although I have confidence that VMW will not trade significantly higher from the current level, I’m not willing to put too much risk on the table.  Earnings reports can offer a significant amount of volatility and if it takes a few days for the reality to sink in, I don’t want to be left holding a straight short position that continues to rally.  So to play for a sharp drop in the stock, I would consider implementing the following series of options trades:

• Buy the May 50 Puts for $1.00 per share
• Sell the May 60 Calls for $1.40 per share
• Buy the May 70 Calls for $0.30 per share

Putting all of these three trades on simultaneously, allows you to capture profits if VMW trades sharply lower between now and May options expiration.  The total dollar amount for this trade is actually a credit of 10 cents per share – which means you are paid to take this position.  (the credit will likely cover commission costs if you use a decent discount broker)

The risk on this trade is that VMW trades sharply higher from this point.  If VMW closes anywhere between $50 and $60 before expiration, all options will expire with no damage.  However, between $60 and $70, there is risk and the worst case scenario would be losing $10.00 per share on the trade.  The calls at $70 keep us from any further exposure.

A price of $70 is very unlikely given the high multiple and the challenges VMW has had in growing top line revenue or bottom line earnings.  But despite the unlikely nature of this loss, one still has to account for that possibility.  On the other hand, if VMW starts trading for a still aggressive 30 times 2011 expectations, the stock could quickly drop below $42.

So consider using this options strategy ahead of the earnings announcement, but as always, do your homework and understand the risks of trading any vehicle before stepping into a trade.

FD: Author does not have a position in VMW

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