Surprisingly, This Sector Could Be Hurt By Higher Wages
Investors are now starting to consider the impact higher wages could have on the stock market. The latest employment report from the Bureau of Labor Statistics shows that wages grew 2.8% compared to a year ago.
While this may sound low, data shows wages are trending higher. That can be seen in the chart below which uses Federal Reserve data to show the trend.
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Source: Federal Reserve
Higher wages will have mixed effects on the economy. Employees will welcome the higher pay which will help them meet higher living expenses. This is especially important since inflation is rising.
The next chart shows wages adjusted for inflation. The inflation data is the consumer price index for all items. When considering inflation, some economists adjust for the cost of food and fuel since they are volatile.
These economists are correct that these expenses are volatile. But they may be 100% correct in excluding these costs when considering the impact of inflation on consumers. Despite the volatility, consumers must pay for food and fuel no matter what the price is.
This chart subtracts inflation from the change in wages. When the value is below zero, consumers are falling behind when inflation is considered.
Source: Federal Reserve
This shows the recent up trend in wages is not only welcome, it is needed for consumers to maintain their spending power. But, higher wages will affect some businesses.
Businesses Will See Mixed Results
Higher wages might allow some consumers to spend more. But, higher wages will also force some businesses to report lower profits. This will be true for businesses where the gains in revenue are less than the increase in expenses.
It may be surprising, but, the gaming sector could suffer. Higher wages would seem to boost discretionary spending and companies in the sector would seem likely to benefit from that. But, any gain could be more than offset by the higher wages the companies must pay in a labor intensive service.
Bloomberg reported that the impact on some stocks has been rapid.
“Penn National Gaming Inc., (Nasdaq: PENN) which is completing the acquisition of Pinnacle Entertainment Inc., fell as much as 9.6 percent in New York. Slot-machine maker Scientific Games Corp., which carries $8.9 billion in debt, lost more than 11 percent, and Caesars Entertainment Corp., which reported weaker trends in Las Vegas this summer, slumped 7.1 percent.”
“Gaming stocks remain under pressure as rising interest rates and higher wage pressure could negatively affect the earnings of these companies,” Chad Beynon, an analyst with Macquarie Bank Ltd. in New York, said in an email.
“The deceleration of Macau September revenues, in addition to negative Vegas trends, continues to escalate questions around 2019 growth.”
“Gambling revenue on the Las Vegas Strip fell 12 percent in August. Revenue in Macau, the world’s largest gambling market, rose 2.8 percent in September, but that was the slowest growth in two years.”
This market action appears to be a bearish breakout for PENN from a trading range.
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 PENN
For PENN, we could sell an October 19 $29 call for about $0.82 and buy an October 19 $31 call for about $0.25. This trade generates a credit of $0.57, 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 $57. The credit received when the trade is opened, $57 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $143. The risk can be found by subtracting the difference in the strike prices ($200 or $2.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($57).
This trade offers a potential return of about 40% 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 PENN is below $29 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 $57 for this trade in PENN.
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.