Being Amazoned Trumps Being Dowed
In the stock market, some events have significant ramifications. For example, being added to a major index like the S&P 500 or the Dow Jones Industrial Average usually results in a surge in the price of a stock. The surge comes from demand provided by index funds.
This was recently demonstrated in the case of Walgreens Boots Alliance, Inc. (NYSE: WBA) which was added to the Dow. Its addition to the Dow came as a surprise, as all Dow announcements do. But, with billions of dollars in index funds, investors had to buy.
They did buy, and the stock price of WBA jumped by more than 8%.
But, the stock gapped down after another surprise announcement. Price pressure resulted from Amazon’s decision to enter WBA’s market and that news swamped a positive earnings report.
Good News and Bad News
The company’s earnings announcement included a great deal of good news. WBA reported a profit of $1.34 billion, or $1.35 a share, compared with a profit of $1.16 billion, or $1.07 a share, in the year-ago period.
On an adjusted basis, earnings per share came in at $1.53, above the $1.48 expected by analysts polled by FactSet.
Sales rose 14% to $34.33 billion. Analysts had expected the company to report $34.1 billion in sales. The company’s effective tax rate was 7.6%, compared with 12.4% in the same quarter a year before.
The only negative in the quarter was the fact that comparable retail sales fell 3.8% in the U.S. and 1.3% on a constant-currency basis internationally.
But, that was offset by other good news. According to The Wall Street Journal, “Walgreens raised its quarterly dividend to 44 cents from 40 cents, a larger increase than those the company has implemented in recent years.
The company also increased the low end of its earnings guidance for the year by 5 cents a share. It now expects per-share earnings of $5.90 to $6.05.”
The company also plans to repurchase as much as $10 billion of its shares. But, traders quickly looked past this, and the stock sold off after Amazon.com Inc. said it was buying online pharmacy PillPack Inc., a move that sent shares of pharmacy and medical-distributor companies tumbling.
Walgreens Chief Executive Stefano Pessina said on an analyst call Thursday that the company doesn’t see “any reason to be worried” about the deal.
This took the stock to a multiyear low and completed what could be a significant topping pattern on the chart.
With prices now showing a potential reversal signal, traders may wait for proof that the company’s CEO is correct, and the Amazon deal is not a reason to worry. There will be time for that statement to be proven before traders jump into the stock.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading 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 WBA
For WBA, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell a July 20 $63 call for about $0.60 and buy a July 20 $65 call for about $0.30. This trade generates a credit of $0.30, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $30. The credit received when the trade is opened, $30 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $170. The risk is found by subtracting the difference in the strike prices ($200 or $2.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($30).
This trade offers a potential return of about 15% of the amount risked for a holding period that is about three weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if WBA is below $63 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 $460 for this trade in PTLA.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.