Different Quarter, Same Story for This Company
Stocks tend to follow certain patterns. This should not be a surprise. Companies, in fact. Follow certain patterns and the stock price reflects the fortunes of the company. Since companies are tied to patterns, we should see recurring behaviors in the price of a stock.
One pattern that companies cannot escape from is the need to report their operating results every three months. Quarterly reports are required by the Securities and Exchange Commission (SEC) for publicly traded companies. These reports provide important information to investors.
The information is new information that traders must immediately consider, and it forces them to reevaluate their opinion of the stock. This often results in rapid price moves which are completely rational and a necessary part of the market.
This week, Best Buy Co., Inc. (NYSE: BBY) reported results and the stock sold off. The company’s performance was in line with expectations but the outlook for the important holiday season was not.
The Latest Results
Best Buy reported results that met Wall Street expectations for its third quarter earnings, posting earnings of $0.78 cents per share. This was exactly what analysts projected, according to FactSet.
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Sales revenue, however, was just a little below what analysts had expected. They had forecast $9.36 billion but the company only achieved $9.32 billion in sales.
The company blamed a series of unique events for the shortfall. Part of the shortfall was due to the delay in the release of iPhone 8 and the iPhone X launch. This year’s hurricanes also hurt sales in the quarter.
The company said it lost more than $100 million in revenue in the quarter because of Apple’s decision to launch its flagship phone later in the year. Industry watchers had expected the phone to be launched by the end of September.
Best Buy also raised an online storm by charging $100 more than the base price for unlocked versions of the iPhone X. The company now says it will offer the high-end phone at its original price but only on an installment basis.
“First, despite our moderate expectations for mobile phone launches in the quarter, revenue in the mobile category was materially lower than expected. This was due to the fact that a major new phone did not launch until November, which is in our Q4,” CEO Joly Hubert said in a statement.
Optimistically, the company should see delayed sales boost the revenue in the next quarter. That doesn’t seem to be what the company is expecting. Management forecast earnings for the fourth quarter that are lower than analysts’ expectation of $2.03 per share.
Management expects earnings of $1.89 to $1.99 per share. Traders reacted by selling the stock. This is not surprising. Traders often sell even when a company meets expectations if the management outlook for the future is lower than expected.
The stock’s trend is shown in the chart below. Even before the earnings related sell off, shares of BBY were lagging the broad stock market. The stock has been trading lower since bad news in August pushed the price down.
The stock has found support near the current price level over the past six months. However, the outlook for lower sales could result in increased selling pressure unless the company recovers quickly. However, data deeper in the financial statements indicates a rapid turnaround is unlikely.
The company’s operating margins are also lower than their historical average. This will hurt the company’s efforts to increase profits. The chart below shows earnings before interest, taxes, depreciation and amortization (EBITDA) as a percent of sales.
Trading the Trend
The trend in the stock is now likely to be down, at least the next few weeks. That trend is likely to endure until there is a significant change in the company’s news. This could come in late December when analysts and possibly the company deliver reports on the outlook for holiday sales.
This indicates traders who want to trade the trend in Best Buy should consider trades that will benefit from moves to the downside.
To benefit from weakness, an investor could buy put options. But, as the chart shows, DKS has been in a downtrend and that has resulted in increased volatility. The higher volatility increased options premiums even more. This is normal behavior when a sell off occurs.
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 Best Buy
For Best Buy, we have a number of options available. Short term options allow us to trade frequently and potentially 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 December 15 $57.50 call for about $0.45 and buy a December 15 $60 call for about $0.15. 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 $220. The risk is found by subtracting the difference in the strike prices ($250 or $2.50 time 100 since each contract covers 100 shares) and then subtracting the premium received ($30).
This trade offers a return of more than 13% for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if Best Buy is below $57.50 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 $220 for this trade in Best Buy.
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.