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Fade the News

Fade the News

Trading often seems to have a language that is all its own. Among the most obvious examples are the terms bull and bear. A bull attacks its enemies by goring with its horns in an upward direction. A bull move in stocks is an up move.

Similarly, a bear attacks by striking opponents with a downward slash. A down move is thus down as a bearish move.

A less familiar phrase is to “fade the news.” This means to take a position opposite to the initial move. If a stock rallies on news, for example, a short trader could be the best course of action. Urban Outfitters Inc. (Nasdaq: URBN) provides a recent example.

URBN daily stock chart

Earnings Boosted the Stock

It was a solid earnings report that carried the stock higher. According to ZACKS, the company recently “delivered better than expected results for the sixth straight quarter. The specialty retailer posted earnings of 70 cents a share that surpassed the Zacks Consensus Estimate of 63 cents and improved sharply from 41 cents in the year ago period.”

Analysts hinted that sturdy sales performance, margin expansion, and a lower tax rate favorably impacted the bottom line.

In the reported quarter, net sales of $973.5 million outpaced the Zacks Consensus Estimate of $968 million and were up 9% year over year. The company witnessed decent performance at its Urban Outfitters, Anthropologie Group and Free People brands.

Sales at Food and Beverage segment increased in double-digits.

At Urban Outfitters, net sales were up 7.2% to $379.2 million, while the same at Anthropologie Group improved 9.4% to $385 million. At Free People, the metric increased 12% to $202.2 million. Meanwhile, Food and Beverage net sales came in at $7.1 million, up 14.5% from the prior-year quarter.

The company’s net sales surged 8.7% to $878.9 million at the Retail Segment and 12.4% to $94.7 million at the Wholesale Segment. The increase in Wholesale Segment net sales can be attributed to sales increase at Free People, Anthropologie Home business and Urban Outfitters’ BDG brand.

Comparable Retail Segment net sales jumped 8% buoyed by double-digit growth in the digital channel and increased retail store sales. Meanwhile, comparable Retail Segment net sales rose 12% at Free People, 8% at the Anthropologie Group and 7% at Urban Outfitters.

This was the fifth successive quarter when each of the company’s brand reported positive comparable Retail Segment net sales.

During the nine months ended on Oct 31, the company opened 14 new locations — four Anthropologie Group stores, four Urban Outfitters stores, three Free People stores and three Food and Beverage restaurants.

It shuttered four locations — two Anthropologie Group stores and one each Urban Outfitters and Free People stores. During the said period, three franchisee-owned Urban Outfitters outlets were opened.

During the reported quarter, the company opened seven new locations — two Urban Outfitters stores, two Anthropologie stores and three food and beverage locations. The company shuttered one each Free People and Anthropologie stores.

In the final quarter, the company plans to open four new outlets and close eight stores.

But, that might not be enough to reverse the stock’s down trend. Now could be time to “fade the news.”

A Trading Strategy To Benefit From Weakness

A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.

In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.

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 traders can consider is the bear call spread. This is a trade that 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. The call is sold to limit the risk of the trade. So this strategy will always generate a credit when it is opened and will always have limited risk.

The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.

bear call spread chart

Source: The Options Industry Council

While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.

You’ll know the maximum potential gain with this strategy as soon as it’s opened. It 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 and is also known.

A Bear Call Spread in URBN

For URBN, we could sell a December 21 $35.50 call for about $0.85 and buy a December 21 $37 call for about $0.35. This trade generates a credit of $0.50, which is the difference in the amount of premium for the call that is sold and the call.

Remember that each contract covers 100 shares, opening this position results in immediate income of $50. The credit received when the trade is opened, $50 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $100. The risk can be found by subtracting the difference in the strike prices ($150 or $1.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($50).

This trade in URBN offers a potential return of about 50% of the amount risked for a holding period that is relatively short. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if URBN is below $35.50 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 $100 for this trade in URBN.

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.