Can Retailers Actually Cut Their Way to Growth?
Retailers have been in the news for months, and the headlines are usually fairly grim. Some retailers have been reporting lower sales while others have slipped into bankruptcy. It’s been enough to raise concerns among analysts that the sector may not survive.
While the news has been bad for the group, some traders believe bad news sets up a buy signal. The idea is that when the news gets too bad, sentiment is overly negative and the group should be considered a buy.
This is called a contrarian strategy and involves, basically, going against the grain of popular opinion. There is some merit in the strategy since the news will usually be overly enthusiastic or overly pessimistic before significant turning points.
However, contrarians face a difficult challenge. They will only be right at important turning points and risk being too early in most trading opportunities. One way to address that timing risk is to wait for the market prices to turn around. That’s the case for some retailers right now.
A Possible Retail Turnaround
Abercrombie & Fitch Co. (NYSE: ANF) is an example. The specialty retailer primarily sells its products through store and direct-to-consumer operations, as well as through various wholesale, franchise and licensing arrangements.
The company operates through two segments: Abercrombie, which includes the company’s Abercrombie & Fitch and abercrombie kids brands, and Hollister, which includes the company’s Hollister and Gilly Hicks brands.
The company offers an array of apparel products, including knit tops, woven shirts, graphic t-shirts, fleece, sweaters, jeans, woven pants, shorts, outerwear, dresses, intimates and swimwear, and personal care products and accessories for men, women and kids under the Abercrombie & Fitch, abercrombie kids, Hollister and Gilly Hicks brands.
ANF has operations in North America, Europe, Asia and the Middle East. The company recently reported that it operated 709 stores in the United States and 189 stores outside of the United States.
In recent months, as the news remained dire for many companies in the retail sector, ANF has been steadily rising.
Now, after the large rally, traders are likely to wait for more news from the industry before another big move in Abercrombie & Fitch unfolds.
A Strategy to Benefit While Waiting for the News
After the big price jump in the stock, we could see Abercrombie & Fitch settle into a trading range. One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the strategy are shown in the following diagram.
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in Abercrombie & Fitch
For Abercrombie & Fitch, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, April 20.
The difference in the exercise prices of the calls or puts is equal to $1.00. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $100 less the premium received when the trade was opened.
Selling the options will generate $1.05 in income ($0.65 from the call and $0.40 from the put). Buying the options will cost $0.70 ($0.45 for the call and $0.25 for the put). This means opening the trade will result in a credit of $0.35, or $35 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($1.00) minus the premium received ($0.35). This is equal to $0.65, or $65 since each contract covers 100 shares. Many brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $65 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $0.35 or $35 per contract.
The potential reward on the trade ($35) is about 54% of the amount risked, a high potential best return on investment for a trade that will be open for about one month. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
This trade could also be closed out early to reduce the potential risks of the trade. It could still deliver its maximum gain even if the position is closed before the expiration date of the options.
The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.