Plumbing, Cabinets and Doors Could Deliver a 65% Gain
Trade summary: A bull call spread in Fortune Brands Home & Security, Inc. (NYSE: FBHS) using the May 15 $52.50 call option which can be bought for about $2.65 and the May 15 $55 call could be sold for about $0.77. This trade would cost $1.88 to open, or $188 since each contract covers 100 shares of stock.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $1.88. The maximum gain is $312 per contract. That is a potential gain of about 65% based on the amount risked in the trade.
Now, let’s look at the details.
The stock has been in a clear up trend on the daily chart with a series of higher lows and higher highs. This is the simplest definition of an up trend and began forming at the beginning of April as can be seen in the chart below.
A recent earnings announcement will test the strength of the trend. The earnings report offers insights into the company’s outlook according to Business Wire,
The CEO noted. “Despite strong sales and profit growth in the first quarter, we began to proactively take steps to rigorously manage cash and expenses and further strengthen our balance sheet to manage any impact of the COVID-19 pandemic and emerge poised to accelerate share gains in a recovery.”
“We continued to operate well in a challenging environment, and I want to thank our dedicated teammates who have been working tirelessly to keep each other healthy and safe while executing with excellence.
Our strong operating performance in the quarter was evident throughout our business and will distinguish us in a more challenging environment. Our exceptional cabinets results are proof that our pivot plan is now delivering, with more to come.
Our plumbing group outgrew its market even with major business disruption in China, and our doors and decking business delivered double-digit growth at expanding margins.”
For the first quarter of 2020, sales were $1.4 billion, an increase of 6% over the first quarter of 2019. Earnings per share were $0.77, compared to $0.60 in the prior-year quarter. EPS before charges and nonrecurring gains were $0.81, compared to $0.63 the same quarter last year.
Operating income was $155.0 million, compared to $135.6 million in the prior-year quarter. Operating income before charges and nonrecurring gains was $169.8 million, compared to $142.0 million the same quarter last year, up 20 percent.
For each segment in the first quarter of 2020, compared to the prior-year quarter:
- Cabinet sales increased 8%. Accelerated growth in value-priced cabinets more than offset flatter performance in higher-priced products.
- Plumbing sales increased 2%, or 9% excluding the impacts of COVID-19 and foreign exchange. The Company’s Chinese plumbing business was closed for approximately six weeks during the quarter.
- Doors & Security sales increased 6%, driven by double-digit sales growth of doors and composite decking.
Looking ahead, management noted, “the Company started the year with a strong first quarter, reflective of the share gain momentum and operating excellence in each of the businesses. Due to COVID-19, the Company expects a deceleration in its markets in the second and third quarter.
The Company has established plans in each of its businesses to reduce expenses and cash deployment significantly. These actions are already underway, will be implemented in waves, and are expected to offset some of the anticipated demand headwinds.”
The stock has potential to trade near $70, well above the current level but the price level where a double top formed prior to the recent decline.
A Specific Trade for FBHS
For FBHS, the May 15 options allow a trader to gain exposure to the stock. This trade will be open for about six weeks and allows for traders to turn over capital quickly, potentially compounding gains several times a year.
A May 15 $52.50 call option can be bought for about $2.65 and the May 15 $55 call could be sold for about $0.77. This trade would cost $1.88 to open, or $188 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 $1.88.
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 FBHS the maximum gain is $3.12 ($55- $50= $5; 5- $1.88 = $3.12). This represents $312 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $188 to open this trade.
That is a potential gain of about 65% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
A Trade for Short Term Bulls
As with the ownership of any stock, buying FBHS 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 FBHS 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.