Warning: This Stock Looks Ready to Crash

Indicators are used by traders to forecast market moves and many have found success with these tools. I prefer simple chart reading, and one of the simplest ideas on charts is support and resistance.

Support appears to keep prices from falling lower. It is seen as a level on a price chart where buyers come in because they think the stock offers value.

[ad#Google Adsense 336×280-IA]At support, the price often bounces higher.

Resistance is the opposite of support.

Sellers come into the market at resistance because they think the price is too high.

Resistance is the idea behind today’s trade in Internet radio star Pandora Media (NYSE: P).

The company released a better-than-expected earnings report on Aug. 29, and the stock moved more than 23% higher the next day before retreating and closing up only 14% on the day.

The intraday high was at a clear resistance level, and that convinced me that it is time to short.

Pandora seems to be repeating the pattern it followed three months ago. After gapping higher on an earnings report, price was stopped at resistance and fell back into a trading range. That seems likely to happen again.

Volume jumped to about 40 million when earnings were released, up from an average of about 3 million shares a day over the last three months. Some of that volume was probably due to short covering. Almost half of the available shares of Pandora (48%) are sold short as traders have been betting on a decline in the price of the stock. In time, though, the shorts should be winners in Pandora.

Pandora seems to be overvalued on a fundamental basis. In the second quarter, the company reported that it lost 3 cents a share, less than analysts had expected to see. Revenue slightly exceeded expectations, and management hinted that the company could do better than expected next quarter when analysts are expecting to see earnings of a penny a share.

Based on next year’s estimated earnings, Pandora is trading at a price-to-earnings (P/E) ratio of 240, more than 18 times the market average P/E ratio of about 13. This might be a good company, but at that price, Pandora looks like it has little upside for investors.

Traders obviously seem to agree with that assessment given the very large short interest in the stock. Put options offer a way to trade the downside in Pandora, but they are fairly expensive because so many traders seem to believe the stock is overvalued.

December 2012 $12 puts are trading at about $2, making them profitable if Pandora falls below $10 before mid-December. That seems likely to happen if Pandora trades this quarter like it did last quarter when it declined for the next three months after gapping up on the earnings report.

Support during the quarter was established near $9 a share, and at that price the $12 put option would have an intrinsic value of $3, offering a gain of 50%. If there is a general market sell-off, high P/E stocks are often among the hardest hit and we could see P fall below $9.

Action to Take –> Buy Pandora Media (NYSE: P) Dec. 12 puts at $2 or less. Set stop-loss at $1. Set initial price target at $3.

— Amber Hestla-Barnhart

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Source: StreetAuthority

Amber Hestla-Barnhart does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.