Inflation Will Start Where Analysts Aren’t Looking
The hunt for inflation has been underway for years. The goal of inflation hunters is to spot rising prices before they become a problem.
Federal Reserve officials are among the most vigilant inflation hunters. They remember the damage inflation caused in the 1970s and early 1980s. They saw that interest rates could reach more than 15% if inflation becomes firmly entrenched and want to avoid that.
Analysts are always hunting inflation because they want to stay ahead of investment trends. If inflation rises, bond prices will fall and that will result in large losses for many investors. Analysts who find inflation and warn clients will be rewarded for their efforts.
Investors are naturally wary of inflation as are consumers. Both know that higher prices will hurt them, as do manufacturers and even retailers. In short, everyone appears to be searching for the first signs of inflation.
While each group shares a common goal, each uses different tools. Consumers spot the trends at the grocery stores while the Federal Reserve explicitly excludes prices of food and fuel since they are volatile. With so much attention on favored sectors, inflation is likely to appear where it’s less expected.
A Lighting Manufacturer Could Signal Higher Prices
Acuity Brands, Inc. (NYSE: AYI) is a provider of lighting solutions for commercial, institutional, industrial, infrastructure and residential applications throughout North America. The Company offers a portfolio of indoor and outdoor lighting and building management solutions for commercial, industrial, infrastructure and residential applications.
The portfolio of lighting solutions includes lighting products utilizing fluorescent, light emitting diode (LED), organic LED (OLED), high intensity discharge, metal halide, and incandescent light sources to illuminate a number of applications.
The solutions portfolio of the Company includes modular wiring, LED drivers, sensors, glass and inverters sold primarily to original equipment manufacturers (OEMs). Its lighting and building management solutions are marketed under various brand names, including Lithonia Lighting and Holophane.
Through its subsidiary, IOTA Engineering, L.L.C., the Company provides emergency lighting products and power equipment.
The stock has been trending lower as price pressures affect the industry.
Now, those pressures appear poised to accelerate.
MarketWatch reported, that shares of company sold off after the company reported a fiscal fourth quarter profit that beat expectations, but said margins fell amid a sharp rise in input costs.
Net income for the quarter to Aug. 31 rose to $108.2 million, or $2.70 a share, from $90.5 million, or $2.15 a share, in the same period a year ago. Excluding non-recurring items, adjusted earnings per share rose 5% to $2.68, above the FactSet consensus of $2.56. Sales rose 10.8% to $1.06 billion, topping the FactSet consensus of $1.01 billion, while costs of products sold hiked up 17.8% to $648.9 million.
Adjusted operating margin decreased 3.9 percentage points. The company said costs were “well higher” for items such as electronic components, freight, wages, and certain commodity-related items, such as steel.
“Many of these input costs experienced dramatic increases in price in the fourth quarter due to several economic factors, including previously announced and enacted tariffs and wage inflation due to the tight labor market,” said Chief Executive Vernon Nagel.
The decline can be seen in the next chart.
This could be the first signs of inflation, indicating tariffs are going to squeeze profits and potentially be passed on to consumers.
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.
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 AYI
For AYI, we could sell an October 19 $135 call for about $4.55 and buy an October 19 $140 call for about $2.25. This trade generates a credit of $2.30, 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 $230. The credit received when the trade is opened, $230 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $270. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($230).
This trade offers a potential return of about 85% of the amount risked for a holding period that is about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if M is below $135 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 $270 for this trade in AYI.
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.