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Eventually, A Company Needs Profits

Eventually, A Company Needs Profits

Stock prices can become disconnected from fundamentals. At least for a time. In the short run, a great story can move a stock. But fundamentals drive the long run. Investors sometimes seem to forget this important lesson.

Fortunately, or perhaps unfortunately, the market provides a reminder that fundamentals matter.

Stitch Fix, Inc. (Nasdaq: SFIX) provides an example of that lesson. SFIX is an online personalized styling service company. The company offers apparel, shoes and accessories across categories, brands, product types and price points.

SFIX offers a wide variety of product types, including denim, dresses, blouses, skirts, shoes, jewelry and handbags.

But the company notes that it is more than a fashion retailer. Its “data science capabilities fuel business of rich and growing set of detailed client and merchandise data and proprietary algorithms. The company uses data science throughout its business, including prediction of purchase behavior, forecast demand, optimize inventory and design new apparel.”

It’s a story and for a time the story drove the stock higher. This can be seen in the left side of the weekly chart below.

SFIX weekly stock chart

The dramatic decline on the right side of the chart can be explained by fundamentals.

Earnings Lead to a Selloff

The Street noted,

“It might not be such an easy fix for online apparel seller Stitch Fix Inc. (SFIX) , which was falling more than 25.3% in trading [the day earnings were reported] despite topping analysts’ earnings estimates in its fiscal first quarter.

The subscription fashion service failed to meet the all-important active client growth numbers analysts were expecting for the period, with the company reaching 2.9 million active clients, just short of Wall Street expectations of 2.95 million.

The stock rose initially after-hours on the top- and bottom-line beats, but the numbers underneath the surface sunk the company’s stock [after the open].

The company reported revenue of $366.2 million, yielding earnings of 10 cents a share share, topping analysts’ 3 cents per share earnings estimate on revenue of $358 million.”

“We continue to delight clients with our strong assortment by delivering access to the brands they love and new styles they’re excited to discover,” COO and president Mike Smith said. “All of our assortment investments are deeply rooted in direct feedback from clients, so we’re confident they’re going to love our new additions.”

Additionally, the company provided second-quarter revenue guidance between $360 million and $368 million.

However, the stock’s selloff was steep.

SFIX daily stock chart

The stock is now deeply oversold. It may continue lower but for now, a bounce is due in the short run.

A Trade for Short Term Bulls

As with the ownership of any stock, buying SFIX 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.

bull call spread chart

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 SFIX

For SFIX, the January 18 options allow a trader to gain exposure to the stock.

A January 18 $24 call option can be bought for about $1.15 and the January 18 $27 call could be sold for about $0.40. This trade would cost $0.75 to open, or $75 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 $75.

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 SFIX the maximum gain is $2.25 ($27 – $24 = $3.00; $3.00 – $0.75 = $2.25). This represents $225 per contract since each contract covers 100 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $75 to open this trade.

That is a potential gain of about 300% 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.