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This Stock’s Recovery Might Be Over

This Stock’s Recovery Might Be Over

After an impressive rally, a retailer announced earnings that were greeted with selling. ZACKS reported,

“Ross Stores, Inc. (Nasdaq: ROST) reported strong fourth-quarter fiscal 2018 results, wherein top and bottom lines beat estimates and improved year over year. However, the company’s operating profit margin continued to be impacted by higher freight costs and wage-related investments.

Notably, higher freight costs have been a headwind for the company for over a year now. Moreover, Ross Stores expects headwinds related to higher freight costs to persist in fiscal 2019.

Further, Ross Stores expects to witness difficult sales and earnings comparisons with fiscal 2018. Additionally, it expects the retail environment to remain extremely competitive, along with an uncertain macro-economic and political backdrop. Consequently, it provided a soft view for the first quarter and fiscal 2019.”

While the report could be considered conflicting, traders seem to be disappointed by the news and the stock sold off.

ROST daily chart

For the most recent quarter, Ross Store posted earnings of $1.20 per share, which beat the Zacks Consensus Estimate of $1.14 and surpassed the company’s guidance of $1.09-$1.14. Further, earnings increased nearly 1% from $1.19 reported in the prior-year period.

This year-over-year increase came despite the contribution of 10 cents per share from the additional week in fourth-quarter fiscal 2017.

Looking ahead, Ross Stores expects the recent softness in the ladies’ apparel business to have a bearing on comps results for the fiscal first quarter. As a result, it anticipates comps to be flat to up 2% in the fiscal first quarter.

Total sales are estimated to increase 3-6%. Operating margin is projected at 13.4-13.8% compared with 15.1% in the prior-year quarter.

This decline is likely to result from expectations of adverse impacts of the timing of pack-away related expenses, which benefited earnings in the prior-year quarter. Higher freight and wage costs are also likely to contribute to the decline.

Consequently, the company envisions earnings per share of $1.05-$1.11 compared with $1.11 recorded in the prior-year quarter.

The stock could face difficult prospects as the company’s operation face challenges. The longer term chart shows the recent consolidation after a rally.

ROST weekly chart

The stock now faces significant resistance if a rally does develop and that is likely to be significant. In the short run, the path of least resistance on the chart appears to be down.

 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.

bear call spread

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.

Every day, we scan the markets looking for trades that carry 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.

A Bear Call Spread in ROST

For ROST, we could sell an April 18 $90 call for about $2.90 and buy an April 18 $95 call for about $0.80. This trade generates a credit of $2.10, 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 $210. The credit received when the trade is opened, $210 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $290. 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 ($210).

This trade offers a potential return of about 72% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if ROST is below $90 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 $290 for this trade in ROST.

For more information on options click here for our free guide, The Ultimate Guide to Options Trading.