Discount Retailers Could Win In a Slow Economy
Analysts are increasingly worried about the possibility of an economic slowdown. If the economy slows, there are a number of companies that could see sales fall and falling sales could result in lower earnings. This is especially true of retailers of discretionary goods.
Consumer discretionary, according to Investopedia, is the term given to goods and services that are considered non-essential by consumers, but desirable if their available income is sufficient to purchase them.
Consumer discretionary goods include durable goods, apparel, entertainment and leisure, and automobiles. The purchase of consumer discretionary goods is also influenced by the state of the economy, which can affect consumer confidence.
However, there could be at least one consumer discretionary retailer that could escape the harm of a slowdown.
Five Below Inc. (Nasdaq: FIVE) is a chain of discount stores that sells products that cost up to $5. The target demographics are children, adolescents, teens, and female. Stores are typically located in strip malls as opposed to standing alone.
More specifically, the companyv “is a store with unlimited possibilities where tweens, teens and beyond are free to Let Go & Have Fun in a color- popping, music pumping, super-fun shopping experience where you’ll always find the coolest stuff for $5 or less making it easy to say YES and smile big with our tech, tees, sports balls, beauty, candy, remote control toys and SO much more for literally everyone!”
In an economic downturn, $5 splurges could hold their popularity.
Earnings Are Already Strong
Recently, FIVE announced its quarterly earnings and as The Street reported,
“Shares of discount retailer FIVE jumped…after the company received a ratings upgrade from Loop Capital analyst Anthony Chukumba.
Chukumba raised his rating on the stock to “buy” from “hold” and lifted his one-year price target to $120 from $110.
Five Below is more “economic-downturn resistant” than most retailers and has a long square-footage-growth runway ahead of it, Chukumba said in a research note.
The rebound stood in stark contrast to the action the day after the announcements when the company provided “decent third quarter earnings but mixed guidance for the fourth quarter prompted investors to push the company’s shares down more than 6% on Friday.
Five below posted third-quarter earnings of 22 cents a share on sales of $312.8 million, though reduced its fourth-quarter earnings guidance to between $1.53 and $1.57 – below consensus views of $1.57 a share.”
This could explain the stock’s recent down trend.
A Trade for Short Term Bulls
As with the ownership of any stock, buying FIVE could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for FIVE
For FIVE, the January 18 options allow a trader to gain exposure to the stock.
A January 18 $105 call option can be bought for about $3.45 and the January 18 $110 call could be sold for about $1.95. This trade would cost $1.50 to open, or $150 since each contract covers 100 shares of stock.
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 spent to open the trade, or $150.
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 FIVE the maximum gain is $3.50 ($110 – $105 = $5.00; $5.00 – $1.50 = $3.50). This represents $380 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $150 to open this trade.
That is a potential gain of about 233% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.