Struggling Toymaker Takes Another Hit
Traders know that stocks tend to move in trends. Higher prices often lead to even higher prices in up trends and lower prices tend to precede even lower prices in down trends. Some traders may not think about why the trends exist, but the trend can often be tied to the news cycle.
In the news cycle, whether it is a political story, or the local crime beat, or the news reported by and about a publicly traded company, the stories often follow a similar trend. Bad news often follows bad news and good news often follows good news.
For some time, the toy maker Mattel Inc. (NYSE: MAT) seems to have been locked in a cycle of bad news. The latest news is that the company’s equity and debt ratings were cut following disappointing holiday earnings and declining sales for the world’s biggest toymaker.
Analysts at Jefferies cut Mattel’s rating to underperform from hold in a note to clients that was released this week. The analyst did slightly increase bumping its price target on the maker of Barbie Dolls and other popular toys to $13 a share from a previous price target of $12.50.
The downgrade comes after Fitch Ratings announced its decision last week to lower its debt rating for Mattel, pushing the company even deeper into junk status. Fitch cut its bond rating by two grades, to B+, based on concerns that Mattel’s leverage ratio could impact access to credit lines from US banks.
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Fitch noted, “Execution missteps, including the inability of the company to effectively respond to evolving play patterns and ongoing retail challenges, with retailers cutting back on inventory purchases, and most recently the September 2017 bankruptcy of Toys ‘R’ Us, Inc., have pressured operating results and cash flow.
Mattel’s challenges are expected to remain obstacles to near-term EBITDA [earnings before interest, taxes, depreciation and amortization] improvement, despite recently announced initiatives to drive topline growth and cost reductions.”
The Stock Reflects the Bad News
The downgrades are likely to add new pressure to the stock which has been in a down trend for nearly two years.
In the short run, the stock is unlikely to move higher until the company delivers some good news. That could, potentially, come in April when Mattel announces earnings. However, the stock has a tendency to sell off in the days after its quarterly earnings announcement.
On average, shares of Mattel fall by 14% in the week after the earnings announcement. This comes despite the fact that the company consistently beats estimates by an average of 24.7% over the past five years. However, the last two quarters have seen large misses.
Large misses explain why the stock is prone to gaps.
Gaps are a sign of volatility and they increase the premiums on options, making options a potential source of income.
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 MAT
For MAT, 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 March 16 $16.50 call for about $0.55 and buy a March 16 $17.50 call for about $0.20. This trade generates a credit of $0.35, 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 $35. The credit received when the trade is opened, $35 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $65. The risk is found by subtracting the difference in the strike prices ($100 or $1.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($35).
This trade offers a potential return of about 53% of the amount risked for a holding period that is about two weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if MAT is below $17.50 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 $65 for this trade in MAT.
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.