Equity markets have been trading more so on fads, memes and headlines then on company fundamentals lately. And since February, stock prices have been whipsawed by headlines of tariff wars.
Now at least we are in the middle of an earnings season so fundamentals matter. But even then, company report cards almost don’t matter as much as forward guidance. Management must deliver amazing forward guidance, or else the short-term reaction to the company’s stock is harsh.
Case in point was the reaction to a recent Macy’s (NYSE:M) earnings report where the stock fell 15% without any major piece of bad news. This morning Kohl’s (NYSE:KSS) also reported earnings and it too is under pressure in spite of management beating both the top- and bottom-lines. KSS also increased forward guidance, but Wall Street was expecting more of an increase than that.
It all comes down to expectations. Coming into the earnings event, KSS stock had rallied 20% in three months. This is in Amazon (NASDAQ:AMZN) stock performance territory. So a 2% dip doesn’t change the trajectory much as nothing goes up in a straight line forever.
The fundamentals for Kohl’s have not changed on the back of this report. Management delivered a win and they forecast another good result in three months. But perhaps the forward guidance was muted for concerns over looming uncertainties. So this is most likely a case of under-promise-and-over-deliver.
The economy is still firing on all cylinders despite an ongoing U.S. Fed rate hike cycle. We are not likely to have runaway rising rates for as long as the Eurozone maintains its yields at zero or negative. And therein lies the opportunity for 2018.
The economic environment for KSS stock and other retailers like T.J. Maxx (NYSE:TJX) and Macy’s is likely to persist as favorable for the rest of the year. But I am not one to chase upside hopium, especially when the retail stocks are up so high already.
So instead of buying KSS stock outright and risking $77-per-share without leaving any room for error, I use options to better position my risk. There, I can create a buffer between the current price and where I want to own the shares.
Fundamentally, Kohl’s stock is not expensive from a price-to-earnings ratio standpoint. So it won’t be a major financial debacle if I own the shares at a 20% jump from current levels.
The rally in KSS was technical on a weekly basis. Moreover, at current levels, it may be at the precipice of yet another leg higher, albeit after a dip. But usually I like to wait for the confirmation of the breakout before setting up my upside of hopium.
In other words, for the time being I have more faith in proven downside support than upside promise. I will use this short-term negative reaction to the earnings headline to sell downside risk into what others fear for the opportunity to create income with no out-of-pocket expense.
How to Trade KSS Stock Today
Wall Street experts agree since they are mostly in a “Hold” position on KSS stock as it trades in the middle of their price ranges.
The Trade: Sell the KSS Jan 2019 $60 naked put. This is a bullish trade, where I collect $2 to open. Here, there is an 85% theoretical chance of success. But if the price falls below the strike, then you accrue losses below $58.
Those who want to mitigate that risk can sell spreads instead.
The Alternate Trade: Sell the KSS Jan 2019 $62.5/$60 bull put spread. Here, the risk is smaller, yet the spread would yield 15% on risk. Compare this with risking $78 to buy the shares and having to leave no room for error.
It is important to note that today’s trade doesn’t need a rally to profit. I simply need support for KSS stock to hold for the near-term. Time will then do the heavy lifting and premiums will expire in my favor. But just in case, I have to be ready to own the shares at that level.
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Nicolas Chahine is the managing director of SellSpreads.com. As of this writing, he did not hold a position in any of the aforementioned securities. You can follow him as @racernic on twitter and stocktwits.
