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For many years, traders have been looking for the next Microsoft (NASDAQ: MSFT) or the next Wal-Mart (NYSE: WMT). They want to find a small company that is about to become a market leader and the dominant force in its field.
Finding winners that are just beginning to define new consumer markets can be tricky. Take Apple (NASDAQ: AAPL), for example. In the beginning, few traders expected AAPL to be among the biggest winners of the current bull market. The computer maker with a relatively small share of the PC market became the market leader in smartphones and downloaded content.
The biggest winners can also suffer large price drops, as Apple has made abundantly clear recently. This was a fate shared by MSFT and WMT, which both peaked in 1999 before falling more than 40% and spending years in a trading range.
Based on this pattern of boom and bust, it might be easier to find stocks set to suffer big drops than it is to uncover the next big winner. After screening for stocks with triple-digit price-to-earnings (P/E) ratios, a potential indicator of strong investor interest (perhaps exuberance) in a company, Salesforce.com (NYSE: CRM) rises to the top of a list of stocks that could soon disappoint investors.
CRM provides cloud computing and social enterprise software that helps businesses make the most of their sales processes and other internal functions. Its products are popular with businesses, and in the past 12 months, CRM has recorded $2.85 billion in revenue. But the company has not been enjoying exceptional profits from those sales. Heavy spending on R&D has contributed to operating losses in each of the past seven quarters. Analysts are looking for a turnaround and expect to see profits this quarter and earnings growth of 27% a year going forward.
Earnings per share (EPS) are expected to be $1.52 this fiscal year, ended in January, and $1.95 next year. At the time of this writing, CRM is trading at $172.50, giving it a P/E ratio of 113 based on this year's expected earnings and 88 times next year's forecasted earnings. Even if the company meets expectations, the stock seems to be overpriced and vulnerable to a sell-off.
The daily CRM stock chart confirms potential weakness and shows a double-top pattern could be forming with a downside target of $155.33.
In addition to the bearish pattern formation, CRM stock shows a bearish momentum divergence in both the stochastics and Moving Average Convergence/Divergence (MACD) indicators. On the weekly chart (not shown), stochastics just gave a sell signal while MACD is declining. All signs point to a possible drop when CRM reports earnings, which is scheduled for Feb. 28.
Put options allow traders to benefit from a potential price decline without needing to incur the expenses of shorting this high-priced stock. March put options with a strike price of $170 are trading at about $7.40 and could almost double to $14.50 based on the target provided by the topping pattern.
With momentum indicators also pointing to the fact that a top has likely formed, traders should consider buying these options expecting to see a significant price move take place no later than the earnings announcement.
Recommended Trade Setup:
-- Buy CRM March 170 Puts at $8 or less-- Set stop-loss at $5.50 (about one-third of the potential gain)-- Set initial price target at $14.50 for a potential 81% gain in six weeks
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