Traders Can Benefit When the Market Goes Too Far
Sometimes, the market goes too far. This is especially true around earnings reports. For example, a company might report earnings that are better than expected. The stock rallies on the news. A rally is often justified, but at times the rally goes a little further than the fundamentals justify.
That could be the case with Helen of Troy (Nasdaq: HELE), the global consumer products company that offers a range of solutions for its customers through a range of brands.
The company’s diverse product line includes healthcare devices, such as thermometers, humidifiers, blood pressure monitors and heating pads; water filtration systems, and small home appliances, such as portable heaters, fans, air purifiers, and insect control devices.
The beauty segment’s products include electric hair care, beauty care and wellness appliances; grooming tools and accessories, and liquid-, solid- and powder-based personal care and grooming products.
HELE reported earnings per share of $1.87 in the most recent quarter, beating the Zacks Consensus Estimate of $1.44 per share. The company reported revenues of $354.68 million for the quarter ending in May 2018, beating the Zacks Consensus Estimate by 6.41%.
The stock jumped more than 10% on the news.
This is certainly good news, but the rally might be overdone.
Slow Growth Remains a Hurdle
Despite the great quarter, HELE is expected to grow EPS at about 5% a year over the next few years. That’s just one third the pace of the growth over the past five years. Slow growth generally justifies a low price to earnings (P/E) ratio.
After the sharp rally, HELE is trading with a P/E ratio of almost 16. That is above the stock’s historic average of about 15, and the historic average reflects the rapid growth the past few years.
This indicates that fundamentals might not support the optimism of traders. Technical analysis also fails to confirm the nearly unbridled optimism. The long term chart of HELE, using monthly data, is shown below.
The stock had been in a trading range since 2016. This news broke through the upper limit of that trading range and rapidly reached the price target. This target is derived from the expectation that the depth of the pattern can be used to find the size of the expected move after the breakout.
Hitting the initial target does not mean that there is no room for additional up side in the stock. But, it does indicate that the pace of gains is likely to be slow. In the case of HELE, the fundamentals and technicals are combining to deliver a message that the stock could stall after its sharp rally.
A Trading Strategy While Waiting for the Next Leg Up
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 for the short term, 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 HELE
For HELE, 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 an August 17 $120 call for about $3 and buy an August 17 $125 call for about $1.75. This trade generates a credit of $1.25, 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 $125. The credit received when the trade is opened, $125 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $375. The risk is 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 ($125).
This trade offers a potential return of about 53% of the amount risked for a holding period that is about three weeks. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if HELE is below $120 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 $375 for this trade in HELE.
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.