Sometimes, Even Great News Isn’t Enough to Reverse the Trend
News often moves stocks. Occasionally, the move will be in the direction traders expect. For example, a great earnings report followed by an up move in the price of the stock is an expected pattern. Sometimes, the unexpected happens.
An unexpected price move followed what seemed to be good news from Advance Auto Parts, Inc. (NYSE: AAP).
Advance Auto Parts Partners With a Retail Industry Giant
The news from AAP sounds like it should be market moving. As Business Wire reported,
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“Walmart.com and Advance Auto Parts, Inc. (NYSE: AAP), a leading automotive aftermarket parts provider in North America, today announced a comprehensive, strategic partnership that will create an automotive specialty store on Walmart.com.”
Expected to begin rolling out in the first half of 2019, the new omnichannel shopping experience will provide customers with access to Advance’s extensive portfolio of aftermarket automotive parts, accessories and maintenance items.
“This year, we’ve been incredibly focused on building our offering on Walmart.com to ensure we have the specialty assortment that our customers are looking for,” said Phillip Oaks, Vice President and Group General Manager, Retail Merchandising, Walmart eCommerce.
“In line with this focus, we are thrilled to be partnering with Advance, which will bring us its industry leading automotive product assortment and know-how.
This comprehensive partnership will enhance almost every aspect of the automotive customer shopping experience – from the product offering online to fulfillment capabilities.”
The new specialty store will complement Walmart’s automotive offering of common parts and accessories online and in stores, including an extensive assortment of tire, lube and battery services in more than 2,500 Walmart Auto Care Centers across the country.
Launching in phases over the coming year, the specialty store will also feature a variety of Advance’s value-added content and product information.
The companies also plan to work together to explore new fulfillment options that will bring customers unparalleled convenience, including home delivery, same-day pickup in a Walmart or Advance store and installation of some parts.
“This is an exciting partnership for both Advance and Walmart customers,” said Tom Greco, President and CEO, Advance Auto Parts.
“At Advance, we are absolutely committed to building a best-in-class omnichannel experience and Walmart is an undisputed omnichannel leader.
Partnering with Walmart enables us to share our extensive product offering and trusted advice with an increased number of do-it-yourself customers and supports our long-term strategic objectives.”
An Unexpected Market Reaction
While this seems like it should be a bullish factor for the stock, traders sold on the news.
The longer term chart uses weekly data and shows the significance of the sell off from a technical perspective. Resistance is evident on the chart and it will most likely be some time before AAP can rally through the $170 level which has been formidable.
Fundamentals could explain the sell off. AAP is trading at almost double the industry average price to earnings ratio and more than three times the industry average price to sales ratio.
A Trading Strategy to Benefit from Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
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 traders can consider is the bear call spread. This is a trade that 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. The call is sold to limit the risk of the trade. So this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It 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 and is also known.
A Bear Call Spread in AAP
For AAP, we could sell a November 16 $160 call for about $9.45 and buy a November 16 $165 call for about $7. This trade generates a credit of $2.45, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $245. The credit received when the trade is opened, $245 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $255. The risk can be found by subtracting the difference in the strike prices ($500 or $5.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($245).
This trade offers a potential return of about 96% of the amount risked for a holding period that is about five weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if AAP is below $160 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 $255 for this trade in AAP.
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.