Retailers Require Detailed Analysis
If you were trading in 1999, you might remember it as a time when no matter what you bought, as long as it was a tech stock, the price went up. It was an interesting time to be a trader. But, those days are long gone. Sectors now require more detailed analysis.
This is especially true in the retail sector. We have seen a great deal of news from that sector in the past few years. Often, the news has been negative with bankruptcies rocking the business and many companies with long histories struggling to survive.
Some Good Buys, Some Stocks to Avoid
The retail sector reports earnings relatively late in the earnings season. Reports coming in lately have sent stock prices up or down, depending largely on how analysts interpreted the report. One example is Foot Locker (NYSE: FL).
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The company recently announced earnings and as CNBC reported, the stock price dropped on the news “despite the company reporting an earnings beat for the second quarter of 2018.”
“Shares of Foot Locker were down 12 percent on Friday, the stock’s worst day in a year, after the company posted weaker-than-expected sales for the last quarter.
Foot Locker’s same-store sales for the second quarter increased 0.5 percent versus the 0.7 percent increase expected according to the consensus estimate from FactSet.”
Those sales are not expected to get much better this quarter. “For the third quarter, we still expect comparable sales to be up low single-digits with Q4 strengthening further within that low single-digit range,” the company’s CFO, Lauren Peters, said on a conference call.
“Foot Locker earned 75 cents per share for the quarter, 5 cents better than the consensus analyst estimate from Thomson Reuters.”
The decline can be seen in the chart below.
The daily chart shows the high degree of volatility in the stock. The gaps in the chart are reactions to news, either the company’s own news or news from a company in the sector. The weekly chart, shown next, can be more useful to traders who are interested in identifying the direction of the trend.
The stock has been struggling to recover from the 2017 sell off and this news is likely to set those efforts back by at least several weeks. It seems unlikely that the stock will be able to generate a sustained rally until the next quarterly earnings announcement, and that would require a good report.
A Trading Strategy to Benefit From Potential Weakness
The prospects of further short term gains in FL seem to be remote. But, significant weakness is also unlikely. Traders should consider using an options strategy known as a bear put spread to benefit from the expected trading range in the stock.
This strategy can be profitable when a trader is looking for a steady or declining stock price during the term of the options. The risks and potential rewards of this strategy are illustrated in the payoff diagram shown below.
Source: The Options Industry Council
A bear put spread consists of buying one put and selling another put at a lower exercise price to offset part of the initial cost of the trade. This trading strategy generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally.
The Trade Specifics for FL
The bearish outlook for FL, at least for the purposes of this trade, is a short-term opinion. To benefit from this outlook, traders can buy put options.
A put option gives the trader the right, but not the obligation, to sell shares at a specified price until the option expires. While buying a put is possible, it can also be expensive. The risk of loss when buying an option is equal to 100% of the amount paid for the option.
To limit the risks, a second put can be sold. This will generate income that can offset the purchase price, potentially allowing a trader to buy a put with a higher exercise price. That increases the probability of success for the trade.
Specifically, the September 21 $52.50 put can be bought for about $4.70 and the September 21 $47.50 put can be sold for about $1.42. This trade will cost about $3.28 to enter, or $328 since each contract covers 100 shares, ignoring the cost of commissions which should be small when using a deep discount broker.
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 $328. This loss would be experienced if FL is above $52.50 when the options expire. In that case, both options would expire worthless.
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 FL, the maximum gain is $1.72 ($52.50 – $47.50 = $5; $5 – $3.28 = $3.30). This represents $172 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $328 to open this trade.
That is a potential gain of about 52% of the amount risked in the trade. This trade delivers the maximum gain if FL closes below $47.50 on September 21 when the options expire.
Put 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 $328 for this trade in FL.