Some Companies Create News Needlessly
News can move stock prices. The right kind of news will often be bullish and push prices higher. Bad news can push prices lower. This is a well known relationship in the stock market and the management teams of companies understand this.
Many companies seek to manage the flow of news. They will release updates on their performance every quarter, as required, but management tends to say little more than is absolutely necessary to meet that requirement.
Other companies, at times, see management make what is, in effect, an unforced error, or a statement that doesn’t need to be made yet moves the stock price down because it indicates a bearish factor to analysts.
Papa John’s and the NFL
In December, the founder of Papa John’s International (Nasdaq: PZZA) announced that he will step down as CEO. That move came weeks after he made controversial remarks about national anthem protests by NFL players. The company was forced to later apologize for his remarks.
John Schnatter, who is featured on Papa John’s pizza boxes and in the chain’s commercials, was replaced by Chief Operating Officer Steve Ritchie on Jan. 1. Schnatter is still the company’s largest shareholder and will continue to serve as chairman of the board.
In November, Schnatter sparked outrage by blaming sagging sales at Papa John’s. The pizza company is a top NFL sponsor and advertiser. He said the league’s “poor leadership” in response to the demonstrations during the national anthem hurt viewership and that hurt pizza sales.
At the time, he said, “You need to look at exactly how the ratings are going backwards. Last year the ratings for the NFL went backwards because of the elections. This year the ratings are going backwards because of the controversy. And so the controversy is polarizing the customer, polarizing the country.”
Papa John’s is a long time sponsor of the NFL. And, as the stock chart below shows that Schattner did have a point about pizza sales. The stock has been in a down trend because of lower sales. Traders, however, most likely blame the company rather than the NFL.
NFL games may not be delivering as much in sales as they once did. But, Papa John’s could have responded with new advertising campaigns. That would have been an announcement welcomed by investors. Now, the company is changing its management team and the stock could remain under pressure for some time.
A Trading Strategy to Benefit From Potential Weakness
Because of the fact the stock is overvalued trading at more than 21 times trailing earnings and growing at an expected rate of just 6% a year, plus in a down trend, traders should consider using an best option strategy known as a bear put spread to benefit from the expected price move.
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 Papa John’s
The bearish outlook for Papa John’s, 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 February 16 $62.50 put can be bought for about $3.00 and the February 16 $60 put can be sold for about $2.00. This trade will cost about $1.00 to enter, or $100 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 spend to open the trade, or $100. This loss would be experienced if PZZA is above $62.50 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 PZZA, the maximum gain is $1.50 ($62.50 – $60 = $2.50; $2.50 – $1.00 = $1.50). This represents $150 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $100 to open this trade.
That is a potential gain of about 50% on the amount risked in the trade. This trade delivers the maximum gain if PZZA closes below $60 on February 16 when the options expire. There is a relatively low probability of that according to the options pricing models. That indicates the gain is likely to be less than the maximum possible gain.
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 $100 for this trade in PZZA.