New Highs Set Up a Possible Triple Digit Gain
Earnings led to a break out and a potential trading opportunity in an agricultural stock. The Street reported, “Lamb Weston Holdings (NYSE: LW) soared [recently] after strong sales and earnings growth helped the frozen potato supplier beat Wall Street’s fiscal second-quarter earnings expectations.
The … company reported net income of $140.4 million, or 95 cents a share, up from $119.0 million, or 74 cents a share, a year ago. Adjusted earnings came to 95 cents, up from 80 cents, and beat the FactSet consensus of 84 cents.
Sales totaled $1.02 billion, up 12% from a year ago, and topped the FactSet consensus of $962.7 million. The increase was primarily driven by growth in the company’s global and foodservice segments.
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“In the second quarter, we delivered strong sales, volume and earnings growth across each of our core business segments by continuing to execute well across the organization,” said Tom Werner, president and CEO.
“We’re generating strong cash flow, and we’re investing that cash back into the business to support customer growth, improve manufacturing operations and systems, and bolster our presence in key markets such as Australia and South America.
We’re also returning more cash to shareholders, including recently raising our quarterly dividend by 15%.”
For fiscal 2020, Lamb Weston raised its growth guidance to the high end of mid-single digit percentage range from the mid-single digit range, largely driven by volume as well as modestly higher price-mix.
Werner said that “while overall raw potato supply in and is tight due to relatively poor weather late in the growing season and during the harvest, we expect to have enough raw potatoes to support our volume growth targets for the year.”
The longer term chart using weekly data shows that the recent gains push the stock out of a consolidation pattern that formed after a strong rally in the stock.
This could be a strong technical buy signal as new highs in stocks are generally bullish. The fact that the stock consolidated near a previous high adds to the bullish argument for the stock, since that offered ample opportunity for so called weak hands to sell their holdings.
The break to new highs is likely to be followed by additional buying and that presents a trading opportunity.
A Trade for Short Term Bulls
As with the ownership of any stock, buying LW 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.
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 LW
Every day, we scan the markets looking for trades with low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
For LW, the April 17 options allow a trader to gain exposure to the stock.
An April 17 $95 call option can be bought for about $3.85 and the April 17 $100 call could be sold for about $2.20. This trade would cost $1.65 to open, or $165 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 $165.
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 LW the maximum gain is $3.35 ($100 – $95= $5; $5 – $1.65 = $3.35). This represents $335 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $165 to open this trade.
That is a potential gain of about 103% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.