After a 1,000% Gain, This Stock Is Due For a Pullback
Trees don’t grow to the sky. Market analysts often attribute that statement to the great economist John Maynard Keynes. What Keynes was saying was that economic growth cannot continue upward for years at a time. There is a need for the growth to slow in a vibrant economy.
The same is true for stocks. They cannot simply go straight up for ever. There is a need for pullbacks so that early investors can take profits, if for no other reason. That could be describing the recent price action in Weight Watchers International (NYSE: WTW).
The stock is pulling back despite a relatively strong earnings report.
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Subscriber Growth in the Future Becomes a Concern
MarketWatch reported that, “Weight Watchers International Inc. not only added one million subscribers year-over-year in the second quarter, analysts also highlight that the company is keeping those subscribers for a longer length of time.
Weight Watchers reported a 28% year-over-year rise in subscribers, to 4.5 million, at the end of the second-quarter period, which Chief Executive Mindy Grossman attributed to the appeal of the WW Freestyle program, a summer marketing campaign, and the company’s digital program, including its mobile app.
The company reported earnings of $1.01 per share, far exceeding the FactSet consensus for 88 cents, and revenue of $409.7 million, just below the $410.0 million FactSet consensus.
Weight Watchers also raised its guidance to between $3.10 and $3.25 from $3.00 to $3.20. The FactSet consensus is $2.97.
However, the company expects to end 2018 with about four million subscribers.
“Given the nature of our subscription business model, we anticipate this higher level of subscribers when entering 2019 would alone translate into an EPS [earnings per share] tailwind of approximately 50 cents in 2019,” said Chief Financial Officer Nicholas Hotchkin on the call, according to a FactSet transcript.
Moreover, 21% of subscribers are choosing the initial six-month plan, up from 14% who chose the plan a year ago. And the average retention is hitting “record levels,” Grossman said, at “well over nine months.”
Some analysts were impressed with the performance but not with the stock. “Put simply, not only is Weight Watchers broadening its reach to new audiences, but it is keeping existing members longer than ever before,” said SunTrust Robinson Humphrey analysts in a note.
However the note also highlighted the stock’s vulnerability to a sell off.
“With the recent run in shares, we believe investors were anticipating more of an upward revision to guidance. In particularly, we view the reiteration of end-of-period subscribers as somewhat disappointing although we do believe this is more a factor of conservatism given the number of new initiatives being rolled out for 2018.”
In the past two years, shares gained more than 1,000% before the recent selling.
A Trading Strategy to Benefit From Potential Weakness
The prospects of further short term gains in WTW seem to be remote. But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for WTW
The bearish outlook for WTW, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the August 17 $80 put can be bought for about $2.50 and the August 17 $75 put can be sold for about $0.80. This trade will cost about $1.70 to enter, or $170 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $170. This loss would be experienced if WTW is above $80 when the options expire. In that case, both options would expire worthless.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in WTW, the maximum gain is $3.30 ($80 – $75 = $5; $5 – $1.70 = $3.30). This represents $330 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $170 to open this trade.
That is a potential gain of about 94% of the amount risked in the trade. This trade delivers the maximum gain if WTW closes below $75 on August 17 when the options expire.
Put 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 $170 for this trade in WTW.