Best Buy Stumbles Into a Trading Opportunity
Best Buy (NYSE: BBY) has been a top performer in the stock market recently. It wasn’t that long ago that traders were convinced Amazon would destroy Best Buy. But, those concerns were set aside as the stock reached new highs heading into its latest earnings report.
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But, the earnings report was not enough to keep the stock’s gains intact. The company reported a decline in quarterly online sales growth and offered a profit forecast for the current quarter that fell short of analyst estimates.
Earnings Report Raises Concerns
According to Reuters, “Chief Executive Hubert Joly in a conference call cited a maturing online consumer electronics business for declining web sales growth and said rising transportation costs may pressure current quarter earnings.
The U.S. consumer electronics retailer said in a statement that domestic online sales rose 10.1 percent in its second quarter, ending Aug. 4. That compared with 12 percent in the first quarter and 31.2 percent in the same period a year ago.
Best Buy’s third-quarter profit forecast also disappointed some investors. The retailer said it expects adjusted earnings per share of 79 cents to 84 cents, lower than analyst estimates of 92 cents per share.
Joly said on the conference call that consumer electronics is a more mature category online, in discussing the slow uptick in online sales in the second quarter.
“Consumer (electronics) is one of the first categories that started to move online. So the overall penetration is higher than in other categories,” Joly said.
The company’s investments in making its stores more competitive are bringing more shoppers to its brick-and-mortar locations for products like appliances and large screen televisions, he added.
Joly said higher transportation costs could pressure profits in the third quarter. However, he added investors should find comfort after the retailer raised its annual sales and earnings guidance.”
Analysts Remain Upbeat
Moody’s lead retail analyst Charlie O’Shea agreed with Joly.
“I think it is important to look at the whole picture with Best Buy and not pieces, more people are shopping at their stores, their overall performance this quarter is strong and that is something the street needs to understand,” O’Shea told Reuters.
“Doesn’t matter whether the sale is being made online or at a physical store … those lines in retail have started to blur,” he said.
Online sales make up 15 percent of the company’s total domestic sales and represented a 15 percent share of the U.S. consumer electronics market, as of March. The company has doubled its web business in the past five years.
Looking ahead, Best Buy expects same store sales to increase about 4% this year, up from earlier guidance of 2% growth. Management also increased its earnings guidance to a range of $4.95 to $5.10 from $4.80 to $5.00.
But, the gains will come later. Management expects a drop in its third quarter operating income.
Traders responded by selling the stock.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
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 traders can consider is the bear call spread. This is a trade that 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. The call is sold to limit the risk of the trade. So this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It 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 and is also known.
A Bear Call Spread in BBY
For BBY, we could sell a September 21 $77 call for about $1.89 and buy a September 21 $82 call for about $0.43. This trade generates a credit of $1.46, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $146. The credit received when the trade is opened, $146 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $354. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($146).
This trade offers a potential return of about 41% of the amount risked for a holding period that is about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if BBY is below $77 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 $354 for this trade in BBY.
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.