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What to Expect After a Big Drop

What to Expect After a Big Drop

Among the biggest losers on Friday was Foot Locker, Inc. (NYSE: FL). The stock opened 23% lower and continued falling from there. The sell off was driven by a disappointing earnings report.

Foot Locker reported lower than expected financial numbers in all major categories. This was the second quarter in a row that the company missed expectations across the board. On the bottom line, the company reported earnings per share (EPS) of $0.62. Analysts had expected EPS of $0.90.

EPS were down 34% compared to a year ago. Sales were down just 4.4% compared to a year ago but that number also missed expectations. Foot Locker reported sales of $1.7 billion for the quarter, well below expectations which were set at $1.8 billion.

Management offered several reasons for the disappointing results. They noted the company’s results were adversely impacted by soft performance of “some recent top styles.” Sales of popular styles also missed the company’s internal projections.

Management added that the financial performance was also affected by the lack of innovative new products in the footwear market. Here, they expect more of the same. Management believes “industry dynamics will continue in 2017, as a result of this it expects comparable sales decline in the range of 3-4% in remaining part of 2017.”

Their negative outlook is supported by a key metric. Comparable store sales (comps) fell 6% during the quarter. Comps are a standard metric for retailers that shows how stores open at least one year have performed.

Comparable store sales isolate the performance of the product and show whether growth is coming from product demand or new store openings. In this case, the number shows that consumers were not interested in the products being offered.

Deeper in the report, the numbers were also bearish. Gross margins, a measure of profitability, declined by more than 10%. This indicates revenue may have been driven higher by markdowns in the stores.

Selling, general and administrative costs (overhead expenses) consumed almost 10% more of the total revenue than they did a year ago. This is a sign management has not been able to control costs or could also be due to product markdowns.

At least one analyst remained bullish:

“Nevertheless, we believe by continually capitalizing on opportunities like children’s business, shop-in-shop expansion in collaboration with its vendors, store banner.com business, store refurbishment and enhancement of assortments, Foot Locker is likely to benefit in the long run. International expansion, especially in Europe, is another growth catalyst. Further, the company is enhancing eCommerce platform.”

That outlook is based on the company’s diverse operations which the company notes includes a number of brands and a number of ways for consumers to buy.

However, that is an outlook for the long term. Traders will more likely be interested in what they can expect to see from the stock in the short term. Their first reaction was bearish.

You can see the stock sold off on the last earnings report as well.

How Stocks Perform After Large Selloffs

The question for traders isn’t related to the financials, or even how the company will fare in the company quarter. Traders can focus solely on the large drop. This can be done by looking back through history to find how other stocks have performed after a large drop like this.

The historical results will not provide a 100% accurate forecast of the future. After all, past performance is not a guarantee of future performance. But, the past does offer insights into what we can expect based solely on probability. Past performance is the only data point we have to the future.

To develop a historical perspective, we can complete a back test. The test will focus on what happened after a large, one day decline in the stock price. To do this, we will include the price history of all stocks in the S&P 100. The index is needed because the event is relatively rare.

FL has had just a single one day decline of more than 20% in the past ten years. The stock rebounded and gained more than 30% over the next month. However, we obviously need more than one example to draw a preliminary conclusion of what to expect.

In the S&P 100, we find this setup occurs an average of 5 times a year, not very often. On average, a month later, the stock rebounds 43.6% of the time. When the stock goes up, the average gain is 24.8%. When it fails to rebound, the average loss is about 7.1%.

A Decision Based on Data

Now that we have some data, we face the difficult task of selecting a trading strategy. To do that, let’s review the data.

There is a high likelihood of a decline in the stock since stocks fall 56.4% of the time in the month after the type of selling Foot Locker experienced. However, any additional decline is likely to be rather small, just 7.1% on average.

We also have the performance of FL last quarter. The stock sold off 16% and then declined another 23% in the following weeks.

The best trade will be one that limits risk and takes advantage of the increased volatility. To benefit from volatility, it could be best to sell an option. To limit risk, a spread can be created. For Foot Locker, the best strategy might be a bear call spread.

A bear call spread is a strategy that uses two call options. The options will have the same expiration date but will use different exercise prices. To open the position, one call is sold and a second call with a higher exercise price than the first option will be bought.

Selling a call generates immediate income. Buying the second call limits the upside risk of the trade. The maximum loss will be the difference in the exercise prices of the two options less the premium received when the trade is opened. The maximum gain is equal to the premium received.

The risks and rewards of this strategy are summarized in the chart below.

Source: The Options Industry Council

A Specific Trade in FL

There are options expiring on September 15 available for FL. The $37 call could be sold for about $0.85. The $40 call could be bought for about $0.25. Since each contract covers 100 shares, this trade will result in immediate income of about $60.

The risk is equal to the difference in the exercise prices of the options (or $300) less the premium received. For this trade, the risk is $240. That is also the amount of capital many brokers will require to open the position. That makes this strategy ideal for small investors.

The potential gain of $60 is equal to 25% of the amount of capital risked. This is a significant gain for a trade that will be open just one month.

The maximum gain on this trade will be realized if Foot Locker closes below $37 on the expiration date of the options. The maximum loss on this trade will be realized if the stock price is above $40 when the two options expire.

History tells us that Foot Locker is more likely to drop over the next month than it is to rise. This trade benefits from that tendency. The risks are strictly limited and fully defined when the trade is opened. The risk is actually relatively small, equal to about 7% of the price of 100 shares of Foot Locker.

Foot Lockers’ share holders have higher risks, in dollar terms, than traders using this strategy. They also have higher potential gains but the gains are only likely in the long run. After two bad quarters, the market may take years to recover and push FL to its former highs.