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Upgrades Drive a Gain, and There Could Be More for Traders

Upgrades Drive a Gain, and There Could Be More for Traders

Analysts can have a significant impact on a stock. The question for traders is whether the impact is likely to be short lived or not. In some cases, the analyst action moves the stock and there is a lack of meaningful follow through in the price action.

The truth is that some analyst notes will carry more impact than other notes. The probability that a recent report issued by a major Wall Street firm will be meaningful is fairly high since the report is a rather significant reversal in the opinion of the analyst.

As The Street reported, “Shares of department store chain Dillard’s (NYSE: DDS) climbed higher [recently] after receiving respective upgrades from Wedbush Securities.

DDS daily chart

In two separate notes to clients, Wedbush Securities analyst Jen Redding [recently] upgraded Dillard’s to neutral from underperform amid what she sees as a “reasonable” valuation on the company’s stock. Redding also raised her price target on the shares to $62 from $54.

The upgrade is an about-face from her take on Dillard’s following the retailer’s earnings release in May, when she cut her price target for the second time in a month on concern over sales momentum in a stalling economic environment.

Redding cut her target price on the stock to $55 from $65 on May 16. That followed a previous downgrade and target-price cut on April 22. “

Reversals in analyst opinions can be significant since they are generally based on evidence that the previous expectations no longer apply. For analysts, it can take a significant change in circumstances for an announcement that they have reversed their opinion on a stock.

The previous analyst notes also affected the price of the stock as can be seen in the chart above and the chart below which displays weekly data.

DDS weekly chart

DDS does appear to be trading above resistance and could be set up to challenge the price highs that were reached last summer. A possible catalyst for that move is the potential for more analysts to issue new reports on the stock in the coming weeks that are more bullish than previous reports were.

A Trade for Short Term Bulls

As with the ownership of any stock, buying DDS 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 DDS

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

An August 16 $85 call option can be bought for about $3.50 and the August 16 $87.50 call could be sold for about $1.60. This trade would cost $1.90 to open, or $190 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 $190.

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 DDS the maximum gain is $0.60 ($87.50 – $85= $2.50; $2.50 – $1.90 = $0.60). 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 $190 to open this trade.

That is a potential gain of about 31% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.