Trading a Turnaround Story, Without Taking the Risk of Failure
Source: Foot Locker.com
Companies can endure ups and downs in their businesses. There is sometimes a cycle at work. Economists call it a business cycle and it is marked by highs and lows. In effect, booms and busts. And, the cycles make sense.
Investors, and business owners or the management teams of large companies, pursue profits. When profits are unusually large, new competition enters the field. Competition reduces profits. This is normal and unavoidable. When profits decline, less efficient businesses leave the industry.
Over time, enough inefficient businesses leave that profits return, and the cycle goes on like this. In general terms, the cycle has largely been dominating the retail sector in the past few years.
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Foot Locker Shows Its Ability to Survive
Shares of Foot Locker (NYSE: FL) appear to be rallying off of a bottom after showing investors that the company can adapt to changes in the retail environment. The shares were well off the lows before the company released its earnings last week.
When the company reported its first quarter earnings, traders were pleased the learn that the company topped the expectations of analysts.
Analysts had been looking for earnings per share (EPS) for Foot Locker to drop 8% compared to a year ago, to $1.25. That would be the fifth consecutive quarter where EPS declined.
However, the company reported EPS of $1.45, above the $1.36 reported in the same three months last year.
Analysts had been looking for revenue of $1.97 billion, according to Zacks Investment Research. Same-store sales were expected to drop 3.6%, Consensus Metrix estimates.
Here too the company exceeded expectations. Revenue rose 1.5% compared to a year ago, reaching $2.03 billion. Same-store sales dipped 2.8%, slightly less than expected.
The stock price jumped on the news.
Analysts Turn Bullish
According to investors.com, “Wedbush Securities analyst Christopher Svezia was upbeat ahead of the report, pointing to easier comparisons in the second half of the year, a moderating promotional environment, stabilizing Jordan distribution during the important back-to-school sales period, stronger product from Nike and gathering momentum in other brands.
“Strong full-price sales should generate positive merchandise margin in (the second half of the year) and more than offset higher store labor, supply chain costs, and e-commerce investments,” Svezia said.
“We like the story going into 2018 as FL works diligently on savings, takes a balanced corresponding incremental sales for investment approach, enhances point of sale and its supply chain, works on elevating the consumer experience with partners, and benefits from increased allocations and a better product pipeline.”
Now, traders might be wary of jumping in, worried that the stock could pull back after the sharp rally on the earnings news.
A Trade for Short Term Bulls
As with the ownership of any stock, buying FL 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.
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 FL
For FL, the June 15 options allow a trader to gain exposure to the stock.
A June 15 $55 call option can be bought for about $2.10 and the June 15 $60 call could be sold for about $0.30. This trade would cost $1.80 to open, or $180 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 $180.
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 FL the maximum gain is $3.20 ($60 – $55 = $5.00; $5.00 – $1.80 = $3.20). This represents $60 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $180 to open this trade.
That is a potential gain of about 56% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.
In this trade, options provide income and defined risk. These are the type of strategies that are explained and used in TradingTips.com’s Extreme Profits Calendar service. This service uses seasonals as one indicator in its trade selection process. To learn more about how options can be used to meet your goals, click here for details on Extreme Profits Calendar.