Retail Sector Likely to Remain Volatile
Stocks of retailers are taking on themes of winning or losing. The sector itself is in turmoil and there are winners and losers. There is not really a clear pattern among the winners and losers. Some companies are doing well while their peers languish.
This makes it a difficult environment for investors with a focus on the long term. These investors want clear trends to help them pick stocks. However, this is an ideal environment for traders with a short term focus.
For traders, the goal is to capture volatility. This can be done with various strategies after volatility is identified. In the retail sector, it is fairly easy to identify volatility. Traders can wait for a large move in the stock and then implement a strategy to potentially profit from the price move.
This approach to trading minimizes risks since traders are not forced to take long term positions and they are not forecasting trends that will last for months. They are simply reacting to news and selecting an appropriate strategy.
Michael’s Creates a Trading Opportunity
The Michaels Companies Inc (Nasdaq: MIK) is an arts and crafts specialty retailer in North America. The company’s segments include Michaels-U.S., Michaels-Canada, Aaron Brothers, Pat Catan’s and Darice.
As of January 28, 2017, the Company operated 1,223 Michaels retail stores in 49 states and Canada, with approximately 18,000 average square feet of selling space per store. It operated 109 Aaron Brothers stores in nine states, with approximately 5,500 average square feet of selling space and 35 Pat Catan’s stores in five states, with approximately 32,000 average square feet of selling space.
The Company also operates an international wholesale business under the Darice brand name. The Company’s stores purchase custom frames, framing supplies and mats from its framing operation and subsidiary, Artistree, Inc. (Artistree), which consists of a manufacturing facility and four regional processing centers.
Since the stock began trading in 2014, this mix of businesses has proven to be volatile.
Recently, Michaels Companies reported quarterly earnings of $0.39 per share. This was better than analysts expected, topping the consensus estimate by a penny. Its revenue of $1.156 billion also beat analysts’ expectations of $1.151 billion.
Michaels’ same-stores sales growth of 0.4% missed the Street view for a 0.7% increase. It expects second-quarter same-store sales to be flat. This news may have been a factor behind traders’ reaction to the news.
The stock gapped down on the news as traders sold.
A Trading Strategy While Awaiting Better News
To benefit from the expected weakness in the stock, an investor could buy put options. But, high prices on put options suggests an alternative trading strategy. The option premium is high because the expected volatility of the stock is high. Options that are based on selling an option can benefit from high volatility.
In this case, with a bearish outlook, a call option should be sold.
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 is important to consider is the bear call spread. This trade 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, so this strategy will always generate a credit when it is opened.
The risk profile of this trading strategy is summarized in the diagram below.
Source: The Options Industry Council
The trade has limited up side potential and limited risk. But, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade.
The maximum potential gain with this strategy 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.
A Bear Call Spread in MIK
For MIK, we have a number of options available. Short term options allow us to trade frequently and potentially expand our account size quickly. Short term trades also reduce risk to some degree since there is less time for a news event to surprise traders.
In this case, we could sell a July 20 $20 call for about $0.30 and buy a July 20 $22.50 call for about $0.05. This trade generates a credit of $0.25, which is the difference in the amount of premium for the call that is sold and the call.
Since each contract covers 100 shares, opening this position results in immediate income of $25. The credit received when the trade is opened, $25 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $225. The risk is found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($25).
This trade offers a potential return of about 11.1% of the amount risked for a holding period that is about one month. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if MIK is below $20 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 $225 for this trade in MIK.
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.