How Market Action Can Lead to Action in the Market
One challenge traders face is in identifying potential profit opportunities. There are a number of approaches that can be used to address this challenge. One of the simplest is simply scanning the lists of the biggest market movers on any given day.
Lists of the day’s biggest winners and losers are readily available at a number of web sites. One advantage of this approach is that no software is required. The data is available for free. Another advantage is that this approach will provide new names for traders to consider.
On any given day, many traders will see a new name appear on at least one of the two lists. This presents an opportunity for research and helps traders review companies and even industries they might otherwise not encounter.
Friday’s Market Movers Shows a Trade in a Jeweler
No matter how a trader seeks to generate trading ideas, there will be both advantages and disadvantages to this approach. One of the disadvantages of this approach is the fact there won’t be a clear cut trading strategy and the trader may need extensive research to identify the exact strategy.
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As an example of how the strategy identification process can unfold, consider Signet Jewelers Limited (NYSE: SIG).
Signet Jewelers sells jewelry, watches and associated services in the US, Canada and the United Kingdom. Signet’s brands include Zale Jewelry, Piercing Pagoda, Kay Jewelers, Jared and several regional mall-based brands.
The stock was once a high flyer but has struggled the past few years. The stock traded as high as $150 in 2015.
The company hasn’t changed much since the stock was soaring. Through all of its brands, Signet operates more than 3,500 stores and kiosks. The company also has a division involved in purchasing and converting rough diamonds to polished stones.
Like many retailers, the company also offers financing to customers. This financing facilitates large purchases, an important selling point for jewelers. For example, an engagement ring will be a significant purchase that many customers could not afford without financing.
Management Errors Drove the Bear Market
One reason the stock is under pressure is because the company is facing a massive class-action arbitration case in which 69,000 women who worked for Sterling Jewelers alleged that the company discriminated against them in pay and promotion practices.
A number of former Sterling employees alleged in sworn statements and in interviews with The Washington Post that company leaders had presided over a culture of sexual “preying” on young saleswomen at company events.
The company has said the allegations have no merit. Signet has retained a former federal judge to review company “policies and practices regarding equal opportunity and workplace expectations” and established a special committee focused on “respect in the workplace.”
The legal action could continue to weigh on the company. Many of the allegations are lurid and will be repeated in the press as frequently as reporters can mention them. Given the sheer number of allegations, it is best to assume there will be a penalty to the company.
Unfortunately, that’s not the company’s only problem. There are also questions related to the company’s accounting. These have been extensively covered in the media as well.
The company finances a significant portion of sales, more than 50%, in the Sterling Jewelers division which includes Kay Jewelers, Jared, and smaller regional brands. This percentage has been rising over the past few years.
The large percentage of sales that were financed led some analysts to worry that these stores are using financing to make sales to customers with subprime credit. They point out that there is less financing at the Zales division which outsources its financing. Outsourced financing requires higher credit standards.
To address some of the accounting concerns, the company took several steps including selling $1 billion of its prime-only credit quality accounts receivable to Alliance Data Systems Corporation at par value.
The company entered into a preliminary agreement with Genesis Financial Solutions to service its non-prime accounts receivables. Signet also partnered with Progressive Leading, a subsidiary of Aaron’s, to improve its internal operations.
Over time, Signet intends to fully outsource its secondary credit programs.
Analysts seem impressed with the moves. They expect SIG to report earnings per share (EPS) of $6.49 in the current fiscal year and $6.49 next year. At the current price, the stock is trading with a single digit price to earnings (P/E) ratio.
A Strategy to Trade Signet
SIG is likely to remain in an uptrend for some time given the strength of its core businesses and the recent rally that can be seen in the chart.
When a stock is expected to move higher, traders could consider obtaining long exposure to the stock to profit. A number of options strategies could be used to meet this objective.
Among those strategies is a bull put spread. The risk and reward diagram is shown below and it offers limited risk with limited potential gains. However, it is well suited for a stock which is in an up trend.
Source: The Options Industry Council
This strategy involves two put options. One put option is bought and a second put option with the same expiration date but with a lower exercise price is sold. Selling the put option will generate immediate income, just like the more familiar covered call strategy would. But, unlike a covered call, risk is limited.
Many traders will be familiar with the idea of a covered call. This is a conservative strategy many long term investors use to generate income in stocks they own that are unlikely to make large moves.
Although the bull put spread is different than a covered call, the bull put spread strategy meets the same objective as the covered call which is to generate some income. This trade generates immediate income and carries limited risk.
For SIG, a bull put spread could be opened with the January 19 put options. This trade can be opened by selling the January 19 $50 put option for about $0.80 and buying the January 19 $45 put for about $0.30.
This trade would result in a credit of $0.50, or $50 per contract since each contract covers 100 shares. That amount is also the maximum potential gain of the trade.
The maximum possible risk is the difference between the exercise prices of the two options less the premium received. For this trade, the difference between exercise prices is $5 ($50 – $45). This is multiplied by 100 since each contract covers 100 shares.
Subtracting the premium from that difference means, in dollar terms, the total risk on the trade is then $450 ($500 – $50).
The potential gain is about 11.1% of the amount of capital risked. This trade will be open for about three weeks and the annualized rate of return provides a significant gain.
Options pricing models show there is an 84% probability of success in this trade.
The bull put spread is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that could be lower than owning the stock. This strategy also has a high probability of success.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.