An Earnings Miss Tells Us How to Trade This Retailer
Stocks often make big moves on earnings. This is especially true for small stocks which can move 10% or more in one day when earnings are announced. Moves of that size tend to be rare in companies that are relatively larger.
Because they are relatively rare, large moves in large cap stocks deserve special attention. That means it could be useful to dig into the earning report of Walmart (NYSE: WMT), the nation’s largest traditional retailer with an extensive network of physical stores.
According to reports, the company “delivered a mixed holiday quarter with earnings falling short and online sales growth slowing sharply as it battles Amazon (Nasdaq: AMZN) for retail supremacy.”
Overall, Walmart’s report was disappointing on several levels. Wall Street analysts has been expecting the company to report earnings per share (EPS) of $1.36 on sales that totaled $135.04 billion.
The company delivered EPS of $1.33, three cents below expectations. Sales of $136.3 billion were a little better than expected. A closely watched metric for retailers, same store sales growth of 2.6% was also above expectations.
But, online sales growth slowed. In the US, e-commerce sales were up 23% which was substantially below the 50% growth seen in the third quarter.
Grocery “remains a highlight,” wrote Stifel analyst Mark Astrachan in a note to clients. “While Walmart does not give details on the impact from price investments, we believe they continue to yield results given Walmart’s U.S. grocery business continues to outperform average grocer comps.”
Perhaps most disappointing to traders was the outlook for the current year. Management is expecting EPS of $4.75 to $5. Prior to the announcement, analysts had been expecting EPS of $5.36.
The news sent the share price of Walmart down by almost 10%, a significant drop for such a large company.
Some analysts called the sell a buying opportunity:
“While overall comps were solid and FY19 guidance appears achievable – eCommerce operational challenges, lack of substantial EPS guidance upside, continued gross margin investments in price and technology, and the likely tactical quarterly headwinds on eCommerce investments to drive market share will likely keep stock back,” wrote Cowen’s Oliver Chen, calling any softness in the stock a “buying opportunity.”
This could be a buying opportunity in the long term. But, for now, traders are likely to step aside and pursue more promising opportunities. That creates a potential income opportunity in WMT.
In the short term, WMT is unlikely to move much higher.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. 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 WMT
For WMT, we have a number of options available. Short term options allow us to trade frequently and potentially expand 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 March 16 $97.50 call for about $1.30 and buy a March 16 $100 call for about $0.70. This trade generates a credit of $0.60, 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 $60. The credit received when the trade is opened, $60 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $190. The risk is found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($60).
This trade offers a potential return of about 32% of the amount risked 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 WMT is below $100 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 $190 for this trade in WMT.
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.