A Trade to Benefit From This Retailer’s Costly Decision
Business school professors often explain the stock market as a discounting mechanism. This means investors all around the world are always assessing the future prospects of a company and buying or selling the stock based on their assessment. Investors are, in other words, discounting the future.
There are times when the discounting process is rapid. We see rapid changes in the price of some companies immediately after an earnings report or the release of other important news. These changes can show up as large price moves that occur in just one day.
Some investors might argue this demonstrates the original price was wrong. Others will argue this shows that investors are discounting the future in real time and that the news represents important information that needs to be reflected into the price.
No matter what the reason was, we saw an example of traders reacting to news by Nordstrom, Inc. (NYSE: JWN) when the company announced that investors including a founding family group had suspended attempts to take the company private because of difficulties in arranging debt financing.
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The News Confirms a Trend in the Industry
Nordstrom had announced several months ago that the family group, which owns 31.2% of the company’s stock, was pursuing efforts to take the company private. At that time, sources noted that the family believed it could better manage the company’s operational restructuring and transition to e-commerce away from the scrutiny of public markets.
The family group was reportedly seeking to partner with the buyout firm Leonard Green & Partners LP on the bid. But investment banks were reluctant to provide the amount of debt financing needed to complete the deal, an amount that was believed to be between $7 billion and $8 billion.
Last Friday, representatives of the Nordstrom family group notified the board of directors that it had given up on efforts to take the company private until at least the end of the year. The group cited the difficulty of obtaining debt financing, according to a Nordstrom regulatory filing.
The regulatory filing noted that the possibility of a deal is not completely dead at this time. The group noted that it would explore another bid after the holiday season. Holiday sales are expected to strengthen the company’s financials enough to make the debt relatively attractive.
Nordstrom’s is the just the latest example of problems in the sector. A $2 billion bond offering completed by PetSmart in May to finance its $3 billion acquisition of online rival Chewy has already resulted in significant losses for the investors in the debt.
Another of Nordstrom’s competitors, Neiman Marcus, canceled its plans earlier this year to complete an initial public offering after struggling with its soaring amount of debt.
A number of bad deals has led to pressure in the sector which can be seen in the chart below. SPDR S&P Retail ETF (NYSE: XRT) is an exchange traded fund that tracks the sector and has been in a down trend.
An Immediate Reaction to the News
Nordstrom shares dropped immediately on the news. The stock price declined by more than $325 million, a high price to pay for the decision to not take the company private. But, the steep droop in value could be justified.
The collapse of the deal was a reminder to investors that physical stores in the retail sector face a number of challenges. Competition from Amazon.com, Wal Mart and other online competitors has proven to be difficult to overcome. Several retailers have entered bankruptcy as a result.
In response to the pressures on the sector, some large chains have been exploring private sales. This would free the companies from the constant scrutiny of Wall Street analysts and give management time to respond to the threats the industry faces.
Among the companies looking at going private is one of Nordstrom’s competitors, Hudson’s Bay Co, which owns both the Saks Fifth Avenue and Lord & Taylor retail chains. After the collapse of Nordstrom’s talks, shares of Hudson’s Bay fell as well.
The declines confirmed analysts’ views of the sector. “It’s difficult to make a case for private equity investing in these legacy retail companies when the play is really not about growing the company so much as right sizing it,” said Neil Saunders, retail analyst at Global Data.
The News Confirms the Direction of the Price Trend
Nordstrom has been in an extended downtrend, as the chart below shows.
The stock’s trend reflects broad concerns about the industry. As the chart shows, JWN is in a downtrend and its recent selloff led to increased volatility. The higher volatility seen after the news of the collapsed deal increased options premiums even more. This is normal when a steep selloff occurs.
Now, put options are trading at high prices. Those high prices suggest an alternative strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility. In this case, with a bearish outlook, a call option should be sold.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that is important to consider is the bear call spread. This trade uses two calls with the same expiration date but different exercise prices. Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received.
A Bear Call Spread in JWN
For JWN, we could sell November 17 $42.50 call for about $1.10 and buy a November 17 $45 call for about $0.55. This trade generates a credit of $55, which is the difference in the amount of premium for the call that is sold and the call that is bought multiplied by 100 since each contract covers 100 shares. That is the maximum potential profit on the trade.
The maximum risk on the trade is $195. The risk is found by subtracting the difference in the strike prices ($250 or $1.50 time 100 since each contract covers 100 shares) and then subtracting the premium received ($55).
This trade offers a return of about 28% for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if JWN is below $42.50 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $195 for this trade in JWN.
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