This Stock Could Be In A Hard Hit Sector
Stock market declines like we saw in October invariably lead the question of whether or not a recession is coming. That is because bear markets in stocks have been associated with every recession since 1950. That’s not just an arbitrary date to start measuring the relationship.
That is when monetary policy stabilized after World War II and is a common starting point for measuring economic contractions. While many relationships between the stock market and the economy seem to change over time, the link between recessions and bear markets appears to be stable.
One reason for the stability could be the logical relationship between the two. In recession, sales and earnings decline and the stock prices should reflect the lowered outlook. During an economic decline, some stocks will be hurt more than others.
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Among the hardest hit stocks are likely to be companies in the consumer discretionary sector. These are expenses consumers can cut when the economy weakens. Easy to cut expenses, for many consumers, include gym membership fees and that affects companies like Planet Fitness Inc (NYSE: PLNT)
A Strong Earnings Report Confirms the Outlook for Weakness
PLNT recently announced its latest financial results and Investor’s Business Daily reported that “Wall Street expected Planet Fitness earnings per share to jump 26% to 24 cents, according to Zacks Investment Finance. Revenue was seen popping 31% to $127 million, matching Q2’s strong growth rate.”
The company beat expectations with earnings that “jumped 47% to 28 cents a share. That’s a strong pace, though it ends a three-quarter string of accelerating growth, capped by Q2’s Planet Fitness earnings gain of 55%.
Revenue popped 40% to 136.66 million, the best gain in more than four years. Same store sales increased 9.7%, a slight deceleration from Q2’s 10.2%.
Planet Fitness now sees full-year adjusted EPS up 43% which would be roughly $1.20. The company sees revenue rising 33% and same-store sales 10%. Analysts had expected a 34.5% EPS gain to $1.13 with revenue up about 27%.”
Analysts responded well to the report.
“Cowen senior analyst Oliver Chen was bullish on Planet Fitness stock heading into earnings, rating it as a buy with a $58 price target. He is expecting the firm to post strong membership growth.
He cited research that showed the number of people who belong to a gym — and who indicate they have a Planet Fitness membership — jumped to 18.6%, compared to 17.5% in June and 18% a year ago.”
“Our survey data also indicates PLNT’s strong market-share gains in a highly competitive fitness environment. 2018 YTD, respondents indicating they belong to PLNT increased to 18.3%, which is a +6.9pp improvement since 2014,” he said in a research note.
“During the same time span, we note PLNT’s membership growth outpaced that of competitors, such as 24 Hour Fitness, LA Fitness, locally owned gyms and community-based fitness centers.
Piper Jaffray senior analyst Peter Keith was maintaining an overweight rating on Planet Fitness stock with a price target of $61. He said, in a note to clients, that the company offers “attractive sustainable growth in uncertain times.”
But, traders sold on the news.
The selloff comes with prices near all-time highs and could indicate a reversal in the longstanding up trend.
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 PLNT
For PLNT, we could sell a November 16 $52.50 call for about $0.68 and buy a November 16 $55 call for about $0.15. This trade generates a credit of $0.53, 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 $53. The credit received when the trade is opened, $53 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $197. The risk can be found by subtracting the difference in the strike prices ($250 or $2.50 times 100 since each contract covers 100 shares) and then subtracting the premium received ($53).
This trade offers a potential return of about 27% of the amount risked for a holding period that is about one week. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if PLNT is below $5.50 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 $197 for this trade in PLNT.
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.