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After the Selloff in Kroger, A Butterfly Strategy Can Deliver a Gain

After the Selloff in Kroger, A Butterfly Strategy Can Deliver a Gain

Among the stocks with the biggest losses on Thursday was Kroger Co. (NYSE: KR) which fell 18.89% to close at $24.56. The selling was sparked by the grocery chain’s weaker guidance for the full year which was included in the quarterly earnings announcement released after the close on Wednesday.

Kroger operates a chain of in 2,792 retail food stores under a variety of local banner names in 35 states and the District of Columbia. Operations include 2,255 pharmacies, 782 convenience stores, 311 fine jewelry stores, 220 retail health clinics, 1,453 supermarket fuel centers and 38 food production plants in the US. Stores operate under a variety of brands including Kroger, Ralphs, Fred Meyer and King Soopers.

For the most recent quarter which ended on April 30, the number-one supermarket chain in the world when ranked by grocery revenue, recorded $36.3 billion in sales. This was an increase of 4.9% compared to the same three months a year ago. It was also above the $35.5 billion Wall Street consensus estimate.

Net income for the quarter came in at $303 million, down sharply from the $696 million recorded during the same quarter last year. Excluding one-time items, Kroger reported $0.58 in earnings per share (EPS) for the quarter. This was one cent better than analysts had expected.

Same store sales declined by 0.2%, excluding fuel. This was the third consecutive quarter of a decline in that measure. But, it was better than expected. Analysts had expected a 0.7% decline in this metric. Same store sales including fuel grew 1.6% in the first quarter. This number also topped analysts’ expectations for 0.9% growth in this metric.

Beyond the Numbers: Management’s Assessment

Management noted same store sales for the second quarter are trending positive. Gains in same store sales would mark a return to what traders expect from Kroger, a company that once reported 52 consecutive quarters of same store sales growth.

Management took an optimistic tone on sales. CEO Rodney McMullen noted in a statement that “We are running the business with an eye toward where the customer is going. We are driving our strategy of lowering costs to reinvest in ways that provide the right value to our customers.”

So far, the report looks like good news that should have led to a rally in the stock. But, there were several pieces of bad news that outweighed the good.

Deeper in the press release, management cited some concerns. They attributed some of the sales decline to commodity cost deflation. This argument can be confirmed by government data. The Food at Home category of the Consumer Price Index maintained by the Bureau of Labor Statistics fell 1.1% in the quarter. Lower prices explain some of the decline in same store sales.

They also commented on an increasingly competitive operating environment, particularly in the pricing of staples like milk and eggs. Promotional prices on milk and eggs from Kroger’s competitors forced the grocer to lower its own milk and egg prices to keep customers, and McMullen said that without this price deflation, the grocer’s comparable store sales would have been positive.

More worryingly, in the earnings release, Kroger cut its full-year adjusted earnings forecast from a range of $2.21 to $2.25 per share to a range of $2.00 to $2.05 per share.

Finding a Precedent for What Comes Next

As traders, the question is what happens next. In all likelihood, the answer is that we won’t see much movement in the stock price for at least a few weeks. That is what we saw with Whole Foods Market, Inc. (Nasdaq: WFM), another grocer that recently sold after a disappointing earnings report.

WFM has remained within 10% of its low after its own recent steep sell off. KR is likely to do the same. To benefit from that expected behavior, we can use a short iron butterfly options strategy.

This strategy includes a total of four different options contracts. It consists of being short a call and a put in options with the same exercise price and expiration date. These contracts in effect form the body of the butterfly. The other two legs of the trade consist of a long put and a long call with the same expiration date and exercise prices that are an equal distance from the first exercise price. These are the wings of the butterfly.

The risk profile for this strategy, as provided by The Options Industry Council, is shown below.

This chart indicates the maximum loss occurs if the stock price moves beyond the exercise prices of the long option contracts at expiration. The maximum gain is realized if the stock trades at the exercise price of the short options at expiration.

The Details of the Trade

The short iron butterfly trade delivers a win when the underlying stock trades within a narrow range during the life of the options. For KR, which closed at $24.56, the expected range is 10%. To be conservative, we will use options that allow for a 20% range.

The body of the butterfly will use a $25 exercise price and options expiring July 21. This trade is designed to benefit from an expected narrow trading range over the next month. The wings will consist of a $20 put and a $30 call. These options are trading at the following prices:

  • July 21 $20 put $0.10 (long trade)
  • July 21 $25 call $0.75 (short trade)
  • July 21 $25 put $1.20 (short trade)
  • July 21 $30 call $0.10 (long trade)

The short trades generate $1.95 in credit and the long trades result in a debit of $0.20. Overall, there is a net credit of $1.75 for this trade. This is the maximum gain.

The maximum loss is equal to the  difference in the exercise prices of the options minus the amount of the premium received as a credit when the trade was opened. In this case, the maximum loss is equal to $3.25. That is the difference between the exercise price of the wings and the exercise price of the body of the butterfly ($5) less the premium received ($1.75).

The benefit of an iron butterfly trade lies in the high probability of success. KR has already made a big move. The move was driven by an earnings announcement. Over the next five weeks that this trade will be open for, there is only a small probability of a large move since the company is unlikely to make another major announcement during that time.

The next chart highlights KR’s price movement after previous earnings reports. The green vertical lines in the chart show previous reports.

In the past year, the stock has moved no more than 12% in the month after an earnings announcement. A 20% band is shown as horizontal lines above and below the most recent price bar in the chart. This shows the stock is likely to remain between $20 and $30 per share for some time.

From the day’s price action, we know traders have already reacted to the news that the company released. On Thursday, more than 75.5 million shares of KR traded. This is 763% of the average daily volume over the past three months.

Based on the high volume, it’s likely share holders who wanted out of the stock have sold their position.

One thing that could push KR out of its trading range would be if value investors started buying. Bargain hunters are likely to wait for more news. There is no point rushing in when management is warning that competition is tough and will weigh on profits.

Value investors know they have time to wait for confirmation, as the company’s operating results have improved.

For now, the stock is likely to move within a narrow range as traders wait for news on what comes next. One strategy, a short iron butterfly, allows us to benefit from that waiting period.

 

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