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Fear Drives the Broad Market and Some Stocks

Fear Drives the Broad Market and Some Stocks

Source: AOB.com

The fear index is a popular market indicator. So is the Fear and Greed Index maintained by CNN. The idea behind these indicators is similar.

As CNN explains, “Investors are driven by two emotions: fear and greed. Too much fear can sink stocks well below where they should be. When investors get greedy, they can bid up stock prices way too far.”

Or, in less mathematical terms, as Warren Buffett explains, “they should try to be fearful when others are greedy and greedy only when others are fearful.”

This concept applies to the broad stock market but it can also be applied to individual stocks as well. Recently, one CEO explained that a boost in the company’s business actually depends on fear.

American Outdoor Brands Stumbles

American Outdoor Brands Corp. (Nasdaq: AOBC) recently sold off after negative comments from the company’s management. The negative outlook comes despite the company’s relatively strong performance in the most recent quarter.

The Wall Street Journal noted that AOBC, “…reported a 72% drop in profit to $7.7 million, or 14 cents a share. On an adjusted basis, profit fell to 24 cents a share from 57 cents a share a year earlier. The results easily beat analysts’ projections.

Meanwhile, net sales fell 25% to $172 million, above the consensus forecast of $165.6 million.”

Digging deeper, the gross profit margin narrowed to 33.4% from 39.6% a year earlier, which the company largely blamed on the firearms segment and higher promotional costs.

Sales, which peaked just above $900 million in the business year ended in April 2017 fueled by concerns about tougher gun-ownership laws, are expected to fall for the third consecutive year.

Without “fear-based buying,” Chief Executive James Debney told analysts referring to consumer concerns about tighter gun control policies or personal safety, American Outdoor should return to sales growth next fiscal year.

“It can take up to two years for that correction to take place,” Mr. Debney said during the call. “So certainly still some market contraction we see on the horizon.”

To counter the weakness, the company plans to lower advertising spending and firearms production. Management said AOBC would limit advertising to sustain market share, rather than grow. The company is already the largest U.S. gun maker by sale.

Expansion Plans Aren’t Enough, Yet

AOBC was known as Smith & Wesson Holding Corp. until the company changed its name in 2017 to signify its plans to broaden its product line into the broader outdoor-sports market. In the most recent year, there was some progress but guns and ammunition accounted for about 68% of sales.

The CEO noted that gun makers and sellers have faced increased investors’ pressure and public scrutiny following a series of high-profile shootings this year, adding, “The solution is not to take a politically motivated action.”

However, the company did add “actions of social activists” to its list of risk factors as part of its annual regulatory filings with the Securities and Exchange Commission.

The results will be lower than expected earnings. “That will weigh on its annual profit, which company executives project at 12 cents to 10.50 cents a share, or 40 cents to 50 cents a share on an adjusted basis, compared with analysts’ forecast of 34 cents a share, or 59 cents a share as adjusted.”

A Trading Strategy to Benefit From Potential Weakness

The prospects of a short term rebound in AOBC seem to be remote. Traders should consider using an options strategy known as a bear put spread to benefit from the expected downward price move.

This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.

bear put spread

Source: The Options Industry Council

A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.

The Trade Specifics for AOBC

The bearish outlook for AOBC, at least for the purposes of this trade, is a short term opinion. To benefit from this outlook, traders can buy put options.

A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expire. While buying a put is possible, it can also be expensive.  The risk of loss when buying an option is equal to 100% of the amount paid for the option.

To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.

Specifically, the July 20 $12.50 put can be bought for about $0.50 and the July 20 $10.50 put can be sold for about $0.10. This trade will cost about $0.40 to enter, or $40 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.

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 $40. This loss would be experienced if AOBC is above $12.50 when the options expire. In that case, both options would expire worthless.

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 AOBC, the maximum gain is $1.60 ($12.50 – $10.50 = $2.00; $2.00 – $0.40 = $1.60). This represents $160 per contract since each contract covers 100 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $40 to open this trade.

That is a potential gain of about 300% of the amount risked in the trade. This trade delivers the maximum gain if AOBC closes below $10.50 on July 20 when the options expire.

Put 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 $40 for this trade in AOBC.

You can find more trades like this in the TradingTips.com service, Options Cash Cow. To learn more, click here.