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This Cheap Retailer Could Benefit In Any Economic Scenario

This Cheap Retailer Could Benefit In Any Economic Scenario

With news turning less bullish on the economy, some traders are considering how they can find stocks that could withstand a recession. One candidate could be cheap retailers, not retail stocks that are cheap based on valuation models but stocks of companies that sell products at cheap prices.

The Street reported that one such retailer, Dollar Tree Stores (Nasdaq: DLTR)  rose [recently] after reporting fiscal first-quarter earnings that matched analysts’ forecasts and providing lower guidance for its second quarter and fiscal year – even as it continues to toy with the idea of offering items for more than a buck.

The company posted net income of $267.9 million, or $1.12 a share, vs. $160.5 million, or 67 cents a share, in the comparable prior-year quarter. On an adjusted basis, the company posted per-share earnings of $1.14, matching the consensus forecast of analysts polled by FactSet.

Sales rose to $5.81 billion from $5.55 billion a year ago. Same-store sales increased 2.5% on a constant currency basis, the company said.

However, the company lowered its guidance for both sales and net income for its fiscal second quarter and full year. Dollar Tree now estimates consolidated net sales for the fiscal second quarter in the range of $5.66 billion to $5.76 billion, and per-share earnings in the range of 64 cents to 73 cents, well below the 99 cents a share currently forecast by analysts.

For the full fiscal year, the company now expects net sales of between $23.51 billion and $23.83 billion and per-share earnings of between $4.77 and $5.07, below the current average estimate of analysts polled by FactSet of $5.30 a share.

Shares of Dollar Tree closed up 3.14% to $98.31 on the Nasdaq Stock Market on Thursday.

The company reiterated its plans to close as many as 390 under-performing stores during its fiscal second quarter, which will involve up-front costs – and hence lower near-term earnings – but longer-term savings.

At the same time, the retail chain is still moving ahead with testing lifting its $1 price-point restriction by introducing Dollar Tree Plus! items as a way to boost longer-term revenue. The company also said it was planning on adding adult beverage products to its offerings.

DLTR weekly chart

A Trade for Short Term Bulls

As with the ownership of any stock, buying DLTR could require a significant amount of capital and exposes the investor to standard risks of owning a stock.

To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.

Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.

To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.

This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.

bull call spread

Source: The Options Industry Council

Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.

This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.

A Specific Trade for DLTR

Every day, we scan the markets looking for trades with low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.

When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.

For DLTR, the August 16 options allow a trader to gain exposure to the stock.

An August 16 $105 call option can be bought for about $2.95 and the August 16 $110 call could be sold for about $1.35. This trade would cost $1.60 to open, or $160 since each contract covers 100 shares of stock.

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 $160

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 DLTR the maximum gain is $3.40 ($110 – $105= $5; $5 – $1.60 = $3.40). This represents $340 per contract since each contract covers 100 shares.

Most brokers will require minimum trading capital equal to the risk on the trade, or $160 to open this trade.

That is a potential gain of about 112% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.